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##### Chapter 21 Capital Investment Decisions and Time Value of Money

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Chapter 21 Capital Investment Decisions and Time Value of Money;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%;Requirements;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?;Must show all work

Paper#78315 | Written in 18-Jul-2015

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