The investment committee of Iron Skillet Restaurants Inc. is evaluating two restaurant sites. The sites have different useful lives, but each requires an investment of $1,000,000. The estimated net cash flows from each site are as follows:
The committee has selected a rate of 20% for purposes of net present value analysis. It also estimates that the residual value at the end of each restaurant’s useful life is $0, but at the end of the fourth year, Site A’s residual value would be $300,000.
Instruction
1. For each site, compute the net present value. Use the present value of an annuity of $1 table appearing in this chapter. (Ignore the unequal lives of the projects.)
2. For each site, compute the net present value, assuming that Site A is adjusted to a four-year life for purposes of analysis. Use the present value of $1 table appearing in this chapter.
3. Prepare a report to the investment committee, providing your advice on the relative merits of the two sites.
SOLUTION:
Net present value analysis:
Site A
| Annual net cash flows (at the end of each of 6 years) ................. | Annual net cash flows (at the end of each of 6 years) ................. | Annual net cash flows (at the end of each of 6 years) ................. | Annual net cash flows (at the end of each of 6 years) ................. | Annual net cash flows (at the end of each of 6 years) ................. | Annual net cash flows (at the end of each of 6 years) ................. | $ | 400,000 | ||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | Present value of an annuity of $1 at 20% for 6 years (Exhibit 2) ..... | × | 3.326 | |||
| Present value of annual net cash flows ................... | Present value of annual net cash flows ................... | Present value of annual net cash flows ................... | $1,330,400 | $1,330,400 | |||||||||
| Less amount to be invested ........... | 1,000,000 | 1,000,000 | |||||||||||
| Net present value................................................................................. | $ 330,400 |
Site B
Annual net cash flows (at the end of each of 4 years) ..................... $ 500,000
Present value of an annuity of $1 at 20% for 4 years (Exhibit 2) ..... × 2.589
Present value of annual net cash flows............................................. $ 1,294,500
Less amount to be invested ............................................................... 1,000,000
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