Question 4 Capital Investment Decisions

Los Pollos sells takeaway chicken and related products. The manager, Gus Fring, is considering acquiring an advanced new oven which will substantially reduce the time required to cook chicken and would also enable the store to diversify into the sale of pizza. The cost of the new oven is $55,000. Los Pollos has estimated the oven will have a useful life of five years and will attract annual cash flows of $18,000 in year 1; $25,000 in year 2; $35,000 in year 3; $10,000 in year 4; and $2,000 in year 5.

It is estimated the oven will be sold for $2,000 at the end of its useful life (scrap value).

Los Pollos has a cost of capital equal to 9% and management prefer projects with a payback period of less than 3 years.

1. Calculate the Net Present Value (NPV) of the project. (8 marks)
2. Calculate the Payback Period (PP) of the project. (8 marks)
3. Based on your calculations of NPV and PP, should the management of Los Pollos proceed with the purchase of the oven? Explain shortly why (or why not)? (2 marks)
4. Does the internal rate of return (IRR) equal the cost of capital in this example. Explain shortly why (or why not)? (2 marks).
5. Explain how you would estimate the internal rate of return without accurate calculations. (2 marks)
6. Another investment option for the manager of Los Pollos is to purchase a frying machine for $40 000. The machine is expected to earn annual net cash inflows of $20 000, $30 000, $15 000, and $20 000, before it wears out sufficiently to be unreliable and must be sold for an estimated $10 000. Compare this investment to the investment into the oven. Based on your analysis, explain which investment you would recommend to the manager of Los Pollos. (8 marks)

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Direct Costs: Cost of therapist $250 Cost of products used $3,500 Other supplies $800 TOTAL $4,550 Indirect Cost: indirect cost rate x actual usage of cost driver $66 per operating hour x 4 operating hours = $264 Total Cost: = $4,550 + $264 = $4,814 3. Assume the Hospital applies a cost-based pricing model to charge prices to patients, adding a mark-up of 30%. What price should Heally Good Hospital charge Peter Peters' for his surgery? (2 marks) Cost $4,814 Markup $30% $4,814 x 1.3 $6,258.20 Question 4 Capital Investment Decisions 20 marks Crazy Joan's Mobiles is considering a new machine which will cost $10 000 in the current year, but will affect future cash flows as follows: Year Annual Inflows $2,000 Price 1 2 $3,000 3 $4,000 4 $5,000 5 $6,000 $7,000 6 - - - It is estimated the machine will be sold for $500 at the end of its useful life. Crazy Joan's Mobiles has a cost of capital equal to 15%, and management prefer projects with a payback period of less than 4 years. 1. Calculate the Net Present Value (NPV) of the project: (8 marks) NPV = PV of all inflows - PV of all outflows. PV FV i = 15% Year NPV 0 (10000) 1 2000/(1.15) - 1,739.130435 2 3 000/(1.15)2 = 2,268.431002 4000/(1.159 2,630.06493 5 000/(1.15) - 2,858.766228 6 000/(1.15) 2983.060412 7 500/(1.15) = 3242.456969 5721.909976 $5.721.91 3 4 5 6 2. Calculate the Payback Period (PP) of the project. (8 marks) Amount Amount Recovered In Total Year 1 $2,000 $2,000 N $3,000 $5,000 3 $4,000 $9,000 $5,000 $14,000 5 $6,000 $20,000 6 $7,500 $27,500 Payback = 3 years +1,000/5,000 = 3.2 years 2. Based on your calculations of NPV and PP, should the Crazy Joan's Mobile proceed with the purchase of the machine? Why? (4 marks) Crazy Joan's Mobile should proceed with the purchase of the machine as: The NPV of the project is positive, at $5721.91. The PP of 3.2 years is less than management's preference of 4 years or less and is well within the life of the 6 year project