Intermediate: Calculation of NPV and payback

(a) The management of the Primetaste Restaurant has been experiencing losses in the most recent months and is considering converting its operations to fastfood takeaways.

The fitting-out of the premises will cost £40000, and the equipment will have a life of ten years with a residual value of £1000. However, an £8000 overhaul will be necessary at the end of the fifth year.

Currently, the restaurant costs £30000 per annum to operate and did break even in this past year. The new service will save £1 0 000 of these costs.

Projected sales are 1 000 units per week, for a full 52 weeks per year except in year 5 when the overhaul will enforce a 4 weeks shutdown. Each unit will provide a contribution of 20p.

Required:

(i) The annual cash inflows expected from the new project.

(ii) The net present value of the operation if the management is expecting a 20% rate of return.

(14 marks)

(b) (i) Define the 'Pay-back period', and

(ii) calculate it using the above example: What advantages are claimed for this method?