QUESTION 3: Capital Investment

Total marks for this question: 20 marks

[Suggested time: 36 minutes]

The Breakwater caf is a common eatery that serves, breakfast, lunch and brunch on Mendana Avenue in the centre of Honiara. Due to its popularity, it is considering expanding its outlet. The owner has identified the following alternatives:

• Construct a new restaurant in the newly constructed AJ City mall in East Honiara
• Buy and renovate an old building towards the West end of Honiara for the new restaurant.

The projected cash flows and annual profit from these two alternatives are shown below. The owner of the restaurant uses a 10 percent discount rate.

	Cash outflow	Annual profit
Investment proposal	Year 0	Years 1 to 10	Years 11 to 20
AJ City restaurant	$450 000	$32 500	$32 500
West-end restaurant	250 000	$20,000	-

The Breakwater caf uses straight-line depreciation method. Each of the investment proposals will have zero residual value at the end of the useful life.

REQUIRED

1. Calculate the net present value of each alternative restaurant site.

(6 marks)

1. The owner will consider projects only if they have a payback period of less than six years. She also favours projects that exhibit an accounting rate of return of at least 8 per cent, and bases a project's accounting rate of return on the initial investment in the project.

1. Calculate the payback period for each of the proposed restaurant sites. (3 marks)

1. Calculate the accounting rate of return for each proposed site.

(3 marks)

1. If the owner of the restaurant sticks to her criteria, which site will she choose? Justify your choice. (4 marks)
2. With reference to the owner's current criteria for choosing capital investment proposals, what advice would you give her when assessing capital projects. (4 marks)