Leches operates a chain of sandwich shops
Using payback, rate the return, discounted cash flow models, and profitability index to make capital investment decisions; Calculating IRR
Leches operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of $8,400,000. Expected annual net cash inflows are $1,500,000, with zero residual value at the end of 10 years. Under Plan B Leches would open three larger shops at a cost of $8,250,000. This plan is expected to generate net cash inflows of $1,080,000 per year for 10 years, the estimated useful life of the properties. Estimated residual value for Plan B is $1,000,000. Leches uses straight line depreciation and requires an annual return of 10%
1. Compute the payback period, the ROR, the NPV, and the profitability index of these two plans. What are the strengths and weaknesses of these capital budgeting models?
Advantages of payback period are:
- Payback period is quite simple to calculate.
- It can be a measure of risk inherent in a project. Since cash flows that occur later in a project’s life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are.
- For companies facing liquidity problems, it provides a good ranking of projects that would return money early.
Disadvantages of payback period are:
- Payback period does not take into account the time value of money which is a serious drawback since it could lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method.
- It does not take into account, the cash flows that occur after the payback period is reached.
2. Which expansion plan should Leches choose? Why?
3. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?