Romanos Pizzas, Inc. operates pizza shops in several states. One of the companys most profitable shops is located adjacent to the campus of a large university. A small bakery next to the shop has just gone out of business, and Romanos Pizzas has an opportunity to lease the vacated space for $18,000 per year under a 15 year lease. Romanos management is considering two ways in which the available space might be used.

Alternative 1

The pizza shop in this location is currently selling 40,000 pizzas per year. Management is confident that sales could be increased by 75 percent by taking out the wall between the pizza shop and the vacant space and expanding the pizza outlet. Costs for remodeling and for new equipment would be $475,000. Management estimates that 20 percent of the new sales would be small pizzas, 50 percent would be medium pizzas, and 30 percent would be large pizzas. Selling prices and costs for ingredients for the three sizes of pizzas follow (per pizza):

Selling Price Cost of Ingredients

Small $ 7.70 $ 2.00

Medium. 9.90 3.40

Large 12.50 4.20

An additional $7,500 of inventories would be needed to carry the larger volume of business. This inventory would be recovered at the end of the lease term. The equipment would have a salvage value of $25,000 in 15 years, when the lease ended.

Alternative 2

Romanos sales manager feels that the company needs to diversify its operations. He has suggested that an opening be cut in the wall between the pizza shop and the vacant space and that video games be placed in the space along with a small snack bar. Costs for remodeling and for the snack bar facilities would be $240,000. The games would be leased from a large distributor of such equipment for $30,000 per year. The distributor has stated that based on the use of game centers elsewhere, Romanos could expect about 27,000 people to use the center each year and to spend an average of $5 each on the machines. In addition, it is estimated that the snack bar would provide a net cash inflow of $15,000 per year. An investment of $4,000 in inventories would be needed for the snack bar. This inventory would be recovered at the end of the lease term. The snack bar equipment would have a salvage value of $15,000 in 15 years.

Romanos management is unsure which alternative to select and has asked you to help in making the decision. You have gathered the following information relating to added costs that would be incurred each year under the two alternatives:

Expand Pizza Shop Install Game Center

Salaries. $ 54,000 $ 17,000

Utilities.. 13,200 5,400

Insurance and other. 7,800 9,600

Required:

1. Assuming there are no income taxes, answer the following questions:

1. Compute the expected net annual cash inflows from each alternative.

2. Assume that the companys cost of capital is 16%. Compute the net present value of each alternative.

3. The sales manager is concerned that 27,000 will not use the game center and the snack bar will not provide a cash inflow of $15,000 per year. To insure these results, he thinks an advertising program should be initiated. How much can be spent on such a program each year and still allow Alternative 2 to provide a 16% rate of return (i.e., NPV = 0).

4. If the advertising program is not undertaken, only 23,000 people use the game center each year, and the snack bar provides annual net cash inflow of only $13,000, what is the new net present value for Alternative 2?

2. Assuming the income tax rate is 25% (taxes will have no impact on working capital or salvage value), answer the following questions:

1. Compute the expected net annual cash inflows from each alternative.

2. Assume that the companys cost of capital is 16%. Compute the net present value of each alternative.

3. The sales manager is concerned that 27,000 will not use the game center and the snack bar will not provide a cash inflow of $15,000 per year. To insure these results, he thinks an advertising program should be initiated. How much can be spent on such a program each year and still allow Alternative 2 to provide a 16% rate of return (i.e., NPV = 0).

4. If the advertising program is not undertaken, only 23,000 people use the game center each year, and the snack bar provides annual net cash inflow of only $13,000, what is the new net present value for Alternative 2?