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Milagro Cafe is considering two alternative expansion plans. Plan A is to open four cafes at a total cost of $2, 090,000. Expected annual net
Milagro Cafe is considering two alternative expansion plans. Plan A is to open four cafes at a total cost of $2, 090,000. Expected annual net cash inflows are $400,000, with residual value of $300,000 at the end of six years. Under plan B, Milagro Cafe would open six cafes at a total cost of $2.100,000. This investment is expected to generate net cash inflows of $500,000 each year for six years, which is the estimated useful life of the properties. Estimated residual value of the plan B cafes is zero. Milagro Cafe uses straight-line depreciation and requires an annual return of 10%. Compute the payback period (p. 1267), the accounting rate of return (p. 1269), and the net present value (pp. 1270-1273) of each plan. Use the residual value when calculating the accounting rate of return for plan A, bur assume a zero-residual value when calculating its net present value. What are the strengths and weaknesses of these capital budgeting models? (pp. 1275-1276) Which expansion plan should Milagro Cafe adopt? Why? (p. 1273) Estimate the internal rate of return (1RR) for plan B. How does plan B's 1RR compare with Milagro Cafe's required rate of return? (p. 1274)
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