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Payback period, NPV, IRR , accounting rate of return

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 equipment (including installation of special windows and driveway modifications) is $30,000. Jenna Simon, manager of Bob's, expects the drive-through operation to increase annual sales by $25,000, 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.

Required:

1. Compute the payback period. Is this a good measure of profitability?
2. Compute the NPV. Should Simon accept the proposal? Why or why not?
3. Compute the IRR. How does this compare with the required rate of return? Should Simon accept the proposal?
4. Using the accounting rate of return model, compute the rate of return on the initial investment.

Solution Preview

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 equipment (including installation of special windows and driveway modifications) is $30,000. Jenna Simon, manager of Bob's, expects the drive-through operation to increase annual sales by $25,000, 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.

Required:

1. Compute the payback period. Is this a good measure of profitability?
Payback period is the number of years in which the initial investment is recouped
Sales= $25,000
Contribution margin= 40%
Therefore ...

Solution Summary

Evaluates a capital budgeting decision using payback period, NPV, IRR and accounting rate of return.

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