NPV, ARR and <span title="Payback/Finance/Accounting?">Payback/Finance/Accountin...</span>

Question

Bob’s Big Burgers is considering a proposal to invest in a speaker system that would allow its employees to service drive through customers. The cost of the system is $40000. Jenna Simon, a manager of Bob’s expects the drive through operations to increase annual sales by $25000, with a 40% contribution margin ratio. Assume that the system has an economic life of six years, at which time it will have no disposal value. The required rate of return is 12%. Ignore taxes.

1. Compute the payback period. Is it a good measure of profitability?

2. Compute the NPV. Should Simon accept the proposal? Why or why not?

3. Using the ARR model, compute the rate of return on the initial investment.

Answer 1

Payback period is the time that it takes a project to recover its initial cost from the revenue it generates.

Payback period = Investment required / Net annual cash inflow

= $40,000 / $10,000 = 4 years.

{ Net annual cash inflow = $25,000 * 40% = $10,000. }

&quot;Payback period is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years are required to recover the original investment.&quot;

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Net present value is found by taking the original investment cost, $40,000 (that would be a negative amount since it&#039;s cash out the door), and then adding the present value of the net annual cash inflows expected ($10,000 for 6 years at the required rate of return of 12%). You look up in the present value annuity table the factor for 6 years at 12%, which is 4.111, and multiply by $10,000 to get present value of expected cash inflows = $41,110.

Net present value = $41,110 - $40,000 = $1,110

SInce the net present value is greater than zero, the proposed purchase is desirable since it promises a return greater than the required rate of return.

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IRR Method:

Factor of internal rate of return = Investment required / Net annual cash inflow

= $40,000 / $10,000 = 4.000

Now you look in the annuity table on the 6 period line to find which percentage rate is closest to the factor 4.00, which is 13%. That&#039;s the internal rate of return.