Pepperoni Pizza Company owns and operates 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 16% is expected. To determine this return, regional net income is divided by the book value of fixed assets at the start of the year. Managers of regions earning a return of more than 18% are identified for possible promotion, and managers of regions with a return of less than 14% 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 return 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 $1,000,000 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 $9 each, total sales revenue will be $5,400,000.

The expenses of operating each of the new parlors include variable costs of $5 per pizza and fixed costs (excluding depreciation) of $175,000 per year. Because each of the new parlors has only a five-year life and no salvage value, yearly straight-line depreciation will be $40,000 [($1,000,000 5 parlors) 5 years].

Required

a. Evaluate the desirability of the $1,000,000 investment in new pizza parlors by computing the

internal rate of return and the net present value. Assume a time value of money of 16%. (Refer to

Appendix 12B if you use the table approach.)

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