Locos 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 $8,450,000. Expected annual net cash inflows are $1,690,000 with zero residual value at the end of 10 years. Under Plan B, Locos would open three larger shops at a cost of $8,400,000. This plan is expected to generate net cash inflows of $1,120,000 per year for 10 years, the estimated life of the properties. Estimated residual value is $980,000. Locos uses straight-line depreciation and requires an annual return of 8%.
Requirements
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?
2. Which expansion plan should Locos choose? Why?
3. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?