Problem
Wildcat Pizza, Inc. would like to open a new restaurant in Boston. The initial investment to purchase the building is $420,000, and an additional $50,000 in working capital is required. Since this store will be operating for many years, the working capital will not be returned in the near future.
Wildcat expects to remodel the store at the end of 3 years at a cost of $100,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows:
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Year 1
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$80,000
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Year 2
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$115,000
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Year 3
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$118,000
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|
Year 4
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$140,000
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|
Year 5
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$155,000
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|
Year 6
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$167,000
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Year 7
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$175,000
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The company's required rate of return is 13 percent. Assume management decided to limit the analysis to 7 years.
A. Find the net present value of this investment.
B. Use trial and error to approximate the internal rate of return for this investment proposal.
C. Based on your answer to requirements A and B, should Wildcat Pizza, open the new store? Explain.
D. Calculate the payback period (include working capital in the initial investment). Assuming management requires all investments to be recovered within three years, should Wildcat Pizza open the new store?
E. What is the weakness of using the payback period method to evaluate long-term investments?
Assume the manager of the company wanted to live in Boston and intentionally inflated the projected annual cash receipts so that the proposal would be accepted. The proposal would otherwise have been rejected. Explain how the company's use of a post audit would help to prevent this type of unethical behavior