Compute the payback period
P12-64A (similar to) | Question Help |
Grinders Inc. operates a chain of snack shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of $8,940,000. Expected annual net cash inflows are $1,500,000 with zero residual value at the end of ten years. Under Plan B, Grinders would open three larger shops at a cost of $8,840,000. This plan is expected to generate net cash inflows of $1,050,000 per year for ten years, the estimated life of the properties. Estimated residual value is $950,000. Grinders uses straight-line depreciation and requires an annual return of 8%. LOADING…(Click the icon to view the present value annuity factor table.) LOADING…(Click the icon to view the present value factor table.)LOADING…(Click the icon to view the future value annuity factor table.) LOADING…(Click the icon to view the future value factor table.)Read the requirementsLOADING….Review OnlyLOADING… Click the icon to see the Worked Solution.Requirement 1. Compute the payback period, the ARR, and the NPV of these two plans. What are the strengths and weaknesses of these capital budgeting models? Begin by computing the payback period for both plans. (Round your answers to one decimal place.)
Plan A (in years) | 6.0 |
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Plan B (in years) | 8.4 |
Now compute the ARR (accounting rate of return) for both plans. (Round the percentages to the nearest tenth percent.)
Plan A | 6.8 | % |
---|---|---|
Plan B | 3.0 | % |
Next compute the NPV (net present value) under each plan. Begin with Plan A, then compute Plan B. (Round your answers to the nearest whole dollar and use parentheses or a minus sign to represent a negative NPV.)
Net present value of Plan A | $1,125,000 |
Net present value of Plan B | $(1,354,650) |
Match the term with the strengths and weaknesses listed for each of the three capital budgeting models.
Strengths and weaknesses | Capital budgeting models |
---|---|
Is based on cash flows, can be used to assess profitability, and takes into account the time value of money. It has none of the weaknesses of the other two models. | Net present value |
Is easy to understand, is based on cash flows, and highlights risks. However, it ignores profitability and the time value of money. | Payback method |
Can be used to assess profitability, but it ignores the time value of money. | Accounting rate of return |
Requirement 2. Which expansion plan should Grinders choose? Why? Recommendation: Invest in Plan A. It has the higher net present value. It also has a shorter payback period.Requirement 3. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?The IRR (internal rate of return) of Plan A is between 10% and 12%.This rate exceeds the company’s hurdle rate of 8%.
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