Problem 3 (Total: 18 marks) Parks Automobile Repair Company currently has five repair shops in Hong Kong. Nelson Lee, the president and chief executive officer, is facing a pleasant dilemma: the business has continued to grow rapidly and major shareholders are arguing about different ways to capture more business opportunities. The company requires a 12% rate of return for its investment projects and uses the straight-line method of depreciation for all fixed assets. Currently, the company has $600,000 for further investment and there are two investment alternatives:

Alternative 1: One group of shareholders wants to open another shop in a newly developed suburban community. This project would require an initial investment of $600,000 to acquire all the necessary equipment, which has a useful life of five years with a salvage value of $200,000. Once the shop begins to operate, another $150,000 of working capital would be required; it would be recovered at the end of the fifth year. The expected net cash inflow from the new shop follows:

Year 1 Year 2 Year 3 Year 4 Year 5

$76,000 $125,000 $180,000 $250,000 $310,000

Alternative 2: A second group of shareholders prefers to invest $600,000 to acquire new computerized diagnostic equipment for the existing shops. The equipment is expected to have a useful life of five years with a salvage value of $150,000. Using this state-of-the-art equipment, mechanics would be able to pinpoint automobile problems more quickly and accurately. Consequently, it would allow the existing shops to increase their service capacity and cash inflows by $166,000 per year. The company would need to train mechanics to use the equipment at the very beginning, which would cost $55,000.

Required: (i) Determine the net present value of each of the two investment alternatives. Which investment alternative would you recommend? Briefly explain. (12 marks) (ii) Explain the reasons why the net present value method is generally preferred over the internal rate of return method. (6 marks)