Mastery Problem: Capital Investment Analysis HomeGrown Company HomeGrown Company is a chain of grocery stores that are similar to indoor farmer's markets, providing fresh, local produce, meats, and dairy products to consumers in urban areas. HomeGrown is considering opening several stores in a new city, and has proposals from three contractors (Alpha, Beta, and Gamma companies) who would like to provide buildings for the new stores. The amount of expected revenue from the stores will depend on the design of the contractor. For example, if HomeGrown decides on a more open floor plan, with less shelf space for products, revenue would be lower overall. However, if HomeGrown decides on a very crowded floor plan, it may lose customers who appreciate a more open feel. As the project manager for HomeGrown, you are responsible for deciding which if any of the proposals to accept. HomeGrown's minimum acceptable rate of return is 20%. You receive the following data from the three contractors: Initial Cost Residual Proposal Type of Floor Plan if Selected Value Alpha Very open, like an indoor farmer's market $1,472,000 $0.00 Beta Standard grocery shelving and layout, minimal aisle space 5,678,900 0.00 Gamma Mix of open areas and shelving areas 2,125,560 0.00 You have computed estimates of annual cash flows and average annual income from customers for each of the three contractors' plans. You believe that the annual cash flows will be equal for each of the 10 years for which you are preparing your capital investment analysis. Your conclusions are presented in the following table. Estimated Average Annual Income Estimated Average Proposal (after depreciation) Annual Cash Flow Alpha $313,094 $351,145 Beta 272,019 461,411 Gamma 521,931 598,133 Method Comparison Compare methods of capital investment analysis in the following table to begin your evaluation of the three capital investment proposals Alpha, Beta, and Gamma. You decide to compare four methods: the average rate of return, cash payback period, net present value, and internal rate of return methods. Average Rate of Cash Payback Net Present Internal Rate of Return Method Method Value Method Return Method Considers the time value of money Does not consider the time value of money Easy to compute Not as easy to compute Directly considers expected cash flows Directly considers timing of expected cash flows Assumes cash flows can be reinvested at minimum desired rate of return Can be used to rank proposals even if project lives are not the same Average Rate of Return You begin by trying to eliminate any proposals that are not yielding the company's minimum required rate of return of 20%. Complete the following table, and decide whether Alpha, Beta, and/or Gamma should be eliminated because the average rate of return of their project is less than the company's minimum required rate of return. Complete the following table. Enter the average rates of return as percentages rounded to two decimal places. Estimated Average Average Average Rate Accept or Proposal Annual Income Investment of Return Reject Alpha % Beta Gamma Cash Payback Method You've decided to confirm your results from the average rate of return by using the cash payback method. Using the following table, compute the cash payback period of each investment. If required, round the number of years in the cash payback period to a whole number. Annual Net Cash Payback Proposal Initial Cost Cash Inflow Period in Years Alpha Beta Gamma Net Present Value Even though you're fairly certain that your evaluation and elimination is correct, you would like to compare the three proposals using the net present value method, and get some data about the internal rate of return of the proposals, each of which are expected to generate their respective annual net cash inflows for a period of 10 years. Compute the net present value of each proposal. You may need the following partial table of factors for present value of an annuity of $1. Round the present value of annual net cash flows to the nearest dollar. If your answer is zero enter "0". For the net present value, if required, use the minus sign (-) to indicate a negative amount. Present Value of an Annuity of $1 at Compound Interest (Partial Table) Year 10% 20% 1 0.909 0.833 3.791 2.991 10 6.145 4.192 Alpha Beta Gamma Annual net cash flow Present value factor Present value of annual net cash flows $ $ Amount to be invested Net present value Final Questions After reviewing all your data, answer the following questions (1)-(3). 1. What can you say about each proposal? Internal Rate Proposal of Return Alpha Beta Gamma 2. What can you say about these proposals? a. HomeGrown would be breaking even (i.e., profit = 0) if Alpha's proposal is chosen. b. Only Gamma's proposal is yielding more than HomeGrown's minimum desired rate of return. c. Gamma's proposal is the only proposal that would be acceptable to HomeGrown. 3. Which proposal is the best choice for HomeGrown given the data collected?