The owner of Waco Waffile House is considering an expansion

The owner of Waco Waffile House is considering an expansion of the business. He has identified two alternatives, as follows: Build a new restaurant near the mall. Buy and renovate an old building downtown for the new restaurant. The projected cash flows from these two alternatives are shown below. The owner of the restaurant uses a 14 percent after-tax discount rate. Cash Outflow: Net After-Tax Cash Inflows Investment Proposal Time $539,500 255,ee0 Years 11-20 $86,000 Years 1-18 Mall restaurant Downtown restaurant $86,000 53,5ee Includes after-tax cash flows from all sources, including incremental revenue, incremental expenses, and depreciation tax shield. Use Appendix A for your reference. (Use appropriate factor(s) from the tables provided.) Required: 1. Compute the net present value of each alternative restaurant site. 2. Compute the profitability index for each alternative. 3. How do the two sites rank in terms of NPV and the profitability index?

Solution

Answer 1.

Mall Restaurant:

Cash Outflow = $539,500
Annual Cash Inflow = $86,000
Life of Project = 20 years

Present Value of Cash Inflows = $86,000 * PVA of $1 (14%, 20)
Present Value of Cash Inflows = $86,000 * 6.6231
Present Value of Cash Inflows = $569,586.60

NPV = Present Value of Cash Inflows - Initial Cash Outflow
NPV = $569,586.60 - $539,500
NPV = $30,086.60

Downtown Restaurant:

Cash Outflow = $255,000
Annual Cash Inflow = $53,500
Life of Project = 10 years

Present Value of Cash Inflows = $53,500 * PVA of $1 (14%, 10)
Present Value of Cash Inflows = $53,500 * 5.2161
Present Value of Cash Inflows = $279,061.35

NPV = Present Value of Cash Inflows - Initial Cash Outflow
NPV = $279,061.35 - $255,000
NPV = $24,061.35

Answer b.

Mall Restaurant:

Profitability Index = Present Value of Cash Inflows / Initial Cash Outflow
Profitability Index = $569,586.60 / $539,500
Profitability Index = 1.06

Downtown Restaurant:

Profitability Index = Present Value of Cash Inflows / Initial Cash Outflow
Profitability Index = $279,061.35 / $255,000
Profitability Index = 1.09

Answer c.

Net Present Value:
Rank 1 : Mall Restaurant
Rank 2 : Downtown Restaurant
Profitability Index:
Rank 1 : Downtown Restaurant
Rank 2 : Mall Restaurant