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### Horngren'S Financial And Managerial Accounting

Book edition 6th
Author(s) Tracie L. Miller-Nobles, Brenda L. Mattison
Pages 992 pages
ISBN 9780134486833

# Hill Company 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$8,700,000. Expected annual net cash inflows are$1,550,000 for 10 years, with zeroresidual value at the end of 10 years. Under Plan B, Hill Company would open threelarger shops at a cost of $8,340,000. This plan is expected to generate net cash inflowsof$990,000 per year for 10 years, the estimated useful life of the properties. Estimatedresidual value for Plan B is $1,200,000. Hill Company uses straight-line depreciationand requires an annual return of 10%.Requirements1. Compute the payback, the ARR, the NPV, and the profitability index of thesetwo plans.2. What are the strengths and weaknesses of these capital budgeting methods?3. Which expansion plan should Hill Company choose? Why?4. Estimate Plan A’s IRR. How does the IRR compare with the company’s requiredrate of return? NPV for project A:$824,130

NPV for Project B:-$1,793,646 See the step by step solution ### Step by Step Solution ## Step1: Computation of CB ratios Computation for Project A Payback period ARR NPV Profitability index Computation for Project B Payback period ARR NPV Profitability index ## Step 2: Strength and weaknesses of Capital Budgeting Strength of capital budgeting methods 1. Payback –i) Simplest method ii) Helpful in determine g the risk in terms of cost recovery period 2. ARR – i) Uses the accounting profit ii) Measures the profitability over asset’s life 3. NPV–i) Provides the time value of money ii) Measures the earning capability against the minimum required rate of return 4. IRR– i) Computes the actual rate of return ii) Considers net cash flow over assets entire life Weaknesses of capital budgeting methods 1. Payback –i) Ignores time value of money ii) Do not take consideration of cash flow after payback period 2. ARR – i) Do not use time value of money ii) Only takes accounting profit concept 3. NPV–i) Complex method ii) Requires specialized skill for the use of the method 4. IRR– i) Complex and difficult method ii) Not relevant in all conditions ## Step 3: Recommendation Based on the above analysis, project A provides a good positive NPV of$824,130. Whereas, project B provides a negative NPV. The payback period for project B is also high in comparison to project A. Furthermore, there is also a risk of the collection period.

So, based on these facts and figures project A is recommended

## Step 4: Computation of IRR

IRR

IRR is the rate at which the present value of cash inflow equals initial investment.

Let’s say IRR = R%

Then,

By hit and trial method if R is taken 12.25% for 10 years then,

So the IRR = 12.25%

As compared to required rate of return, IRR is only 2% above the RRR. It means that the project’s NPV would be positive but with lesser degree.