Questions attached

Techniques of Capital Budgeting

1. Mark Gonzalez has a sandwich shop in a downtown Los Angeles. Several of his customers have said that they would purchase from his shop more often if he offered a delivery service. Mark is considering establishing a delivery service to meet the needs of his market. He believes that he will have to purchase a fax machine, install a new phone line for the fax machine, purchase a delivery van, and hire at least one delivery person. Mark asks your advice in determining whether or not he should take on the delivery service venture.

   1. What steps would you recommend that Mark use in reaching a profitable decision?

   2. Explain to Mark what each step involves.

1. You decide to help Mark with his analysis. A good fax machine will cost $500 and functions properly for five years. The phone company charges $300 for installing a new line and $60 a month for the line. A new delivery van costs $20,000 and can be financed for 60 months with a $4,000 down payment. Mark’s bank will finance the van at 5.5% compounded monthly. You calculated his weighted average cost of capital at 8%. You found that a 5-year-old van of this model sells for $5,000. After discussing the business venture with several retired restaurant owners at the local SCORE office, you believe that Mark, after paying his food costs, will increase his breakfast and lunch trade by $2,000 a month. Mark can hire a part time driver for $600 a month. The vehicle depreciates straight line for five years, or $3,000 per year. Mark is a sole proprietor and is in a 20% tax bracket. You estimate it will cost Mark $300 a month to pay for maintenance, upkeep, and insurance on the van. In order to get credit for the answers provided, you must show all your work, how you arrived at the answer provided for each question:

   1. If Mark decides to establish a delivery service and pays for the fax machine in cash, how much cash does he need now?

   2. What is the monthly payment for the delivery van? Hint: Remember to deduct his down payment from the overall calculation.

   3. If the present value of the benefits Mark will acquire by adding this service equals $104,435 and the present value of the costs equals $67,218, what is the NPV?

   4. What is PI of the delivery service?

   5. What is the Payback of the delivery service?

   6. What recommendation would you give Mark with regard to this project?

1. Use the NPV method to determine whether Kyler products should invest in the following projects. In order to get credit for the answers provided, you must show all your work, how you arrived at the answer provided for each question:

   1. Project A – Costs $260,000 and offers seven annual net cash inflows of $57,000. Kyler Products requires an annual return of 16% on projects like A.

   2. Project B – Costs $375,000 and offers 10 annual net cash inflows of $75,000. Kyler Product demands an annual return of 14% on investments of this nature.

   3. Compute the IRR of each project and use this information to identify the better investment.

1. Leslies operates a chain of sandwich shops. The company is considering two possible expansion plans. Plan A would open eight smaller shops at a cost of $8,400,000. Expected annual net cash inflows are $1,500,000, with zero residual value at the end of 10 years. Under Plan B, Leslies would open three larger shops at a cost of $8,250,000. This plan is expected to generate net cash inflows of $1,800,000 per year for 10 years, the estimated useful life of the properties. Leslies requires an annual return of 10%. In order to get credit for the answers provided, you must show all your work, how you arrived at the answer provided for each question:

   1. Compute the payback period, the NPV & ARR for these two plans.

   2. Describe the strengths and weaknesses of each capital budgeting techniques in this case.

   3. Which expansion plan should Leslies choose? Why?

   4. Estimate Plan A’s IRR. How does the IRR compare with the company’s required rate of return?