Question

Mastery Problem: Capital Investment Analysis

HomeGrown Company

HomeGrown Company is a chain of grocery stores that are similar to indoor farmer's markets, providing fresh, local produce, meats, and dairy products to consumers in urban areas. HomeGrown is considering opening several stores in a new city, and has proposals from three contractors (Alpha, Beta, and Gamma companies) who would like to provide buildings for the new stores.

The amount of expected revenue from the stores will depend on the design of the contractor. For example, if HomeGrown decides on a more open floor plan, with less shelf space for products, revenue would be lower overall. However, if HomeGrown decides on a very crowded floor plan, it may lose customers who appreciate a more open feel.

As the project manager for HomeGrown, you are responsible for deciding which if any of the proposals to accept. HomeGrown's minimum acceptable rate of return is 20%. You receive the following data from the three contractors:

Proposal	Type of Floor Plan	Initial Cost if Selected	Residual Value
Alpha	Very open, like an indoor farmer’s market	$1,472,000	$0.00
Beta	Standard grocery shelving and layout, minimal aisle space	5,678,900	0.00
Gamma	Mix of open areas and shelving areas	2,125,560	0.00

You have computed estimates of annual cash flows and average annual income from customers for each of the three contractors' plans. You believe that the annual cash flows will be equal for each of the 10 years for which you are preparing your capital investment analysis. Your conclusions are presented in the following table.

Proposal	Estimated Average Annual Income (after depreciation)	Estimated Average Annual Cash Flow
Alpha	$313,094	$351,145
Beta	272,019	475,608
Gamma	527,245	598,133

Method Comparison

Compare methods of capital investment analysis in the following table to begin your evaluation of the three capital investment proposals Alpha, Beta, and Gamma. You decide to compare four methods: the average rate of return, cash payback period, net present value, and internal rate of return methods.

	Average Rate of Return Method	Cash Payback Method	Net Present Value Method	Internal Rate of Return Method
Considers the time value of money	No	No	Yes	Yes
Does not consider the time value of money	Yes	Yes	No	No
Easy to compute	Yes	Yes	No	No
Not as easy to compute	No	No	Yes	Yes
Directly considers expected cash flows	No	Yes	Yes	Yes
Directly considers timing of expected cash flows	No	No	Yes	Yes
Assumes cash flows can be reinvested at minimum desired rate of return	No	No	Yes	Yes
Can be used to rank proposals even if project lives are not the same	Yes	Yes	No	Yes

Feedback

Review the advantages and disadvantages of each method.

Average Rate of Return

You begin by trying to eliminate any proposals that are not yielding the company’s minimum required rate of return of 20%. Complete the following table, and decide whether Alpha, Beta, and/or Gamma should be eliminated because the average rate of return of their project is less than the company's minimum required rate of return.

Complete the following table. Enter the average rates of return as percentages rounded to two decimal places.

Proposal	Estimated Average Annual Income	Average Investment	Average Rate of Return	Accept or Reject
Alpha	$	$	%	Accept
Beta				Reject
Gamma				Accept

Feedback

Review the definition of average rate of return, and plug the relevant numbers into the formula from the data given.

Cash Payback Method

You’ve decided to confirm your results from the average rate of return by using the cash payback method.

Using the following table, compute the cash payback period of each investment. If required, round the number of years in the cash payback period to a whole number.

Proposal	Initial Cost	Annual Net Cash Inflow	Cash Payback Period in Years
Alpha	$	$
Beta
Gamma

Feedback

Review the definition of cash payback period, and put the relevant numbers into the formula from the data given.

Net Present Value

Even though you’re fairly certain that your evaluation and elimination is correct, you would like to compare the three proposals using the net present value method, and get some data about the internal rate of return of the proposals, each of which are expected to generate their respective annual net cash inflows for a period of 10 years.

Compute the net present value of each proposal. You may need the following partial table of factors for present value of an annuity of $1. Round the present value of annual net cash flows to the nearest dollar. If your answer is zero enter "0". For the net present value, if required, use the minus sign (-) to indicate a negative amount.

Present Value of an Annuity of $1 at Compound Interest (Partial Table)
Year	10%	20%
1	0.909	0.833
5	3.791	2.991
10	6.145	4.192

	Alpha	Beta	Gamma
Annual net cash flow	$	$	$
Present value factor
Present value of annual net cash flows	$	$	$
Amount to be invested
Net present value	$	$	$

Answer 1

Computation of Average Rate of Return
Proposal	Estimated Average	Average Investment ( Initial Inestment + Residual Value)/2 (b)	Average Rate of (a/b)Return	Accept or Reject?
	Annual Income (a)
Alpha	$313,094	$736,000	42.54%	Accept
Beta	$272,019	$2,839,450	9.58%	Reject
Gamma	$527,245	$1,062,780	49.61%	Accept

Computation of Cash Payback period
Proposal	Initial Cost (a)	Annual Net Cash Inflow (b)	Cash Payback Period in Years (a/b)
Alpha	$1,472,000	$351,145	4.19
Beta	$5,678,900	$475,608	11.94
Gamma	$2,125,560	$598,133	3.55

Computation of Net Present Value
	Alpha	Beta	Gamma
Annual net cash flow	$351,145	$475,608	$598,133
Present value factor	4.031	4.031	4.031
Present value of annual net cash flows	$1,415,465.50	$1,917,175.85	$2,411,074.12
Amount to be invested	$1,472,000	$5,678,900	$2,125,560
Net present value	-$56,535	-$3,761,724	$285,514