IRR and NPV with Performance Evaluation Conflict

Pepperoni Pizza Company owns and opertes fast-service pizza parlors throughout North America. The firm operates on a regional basis and provides almost complete autonomy to the manager of each region. Regional managers are responsible for long-range planning, capital expenditures, personnel policies, pricing, and so forth. Each year the performance of regional managers is evaluated by determining the accounting return on fixed assets in their regions; a return of 14 percent is expected. To determine this retun, regional net income is divided by the book value of fixed assets at the start of the year. Managers of regions earning a retun of more than 16 percent are identified for possible promotion, and managers of regions with a return less than 12 percent are subject to replacement.

Mr. Light, with a degree in hotel and restaurant management, is the manager of the Northeast region. He is regarded as a "rising star" and will be considered for promotion during the next two years. Light has been with Pepperoni for a total of three years. During that period, the reurn on fixed assets in his region (the oldest in the firm) has increased dramatically. He is currently considering a proposal to open five new parlors in the Boston area. The total project involves an investment of $640,000 and will double the number of Pepperoni pizzas sold in the Northeast region to a total of 600,000 per year. at an average price of $6.00 each, total sales revenue will be $3,600,000.

The expenses of operating each of the new parlors include variable costs of $4.00 per pizza and fixed costs (excluding depreciation) of $80,904 per year. Because each of the new parlors has only a five-year life and no salvage value, yearly staight-line depreciation will be $25,600 [($640,000 / 5 parlors) / 5 years].

Required

a. Evaluate the desirability of the $640,000 investment in new pizza parlors by computing the internal rate of return and the net present value. Assume a time value of money of 14 percent.

b. If Light is shrewd, will he approve the expansion? Why or why not? (additional computations are suggested)

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