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# Cost of Capital, Payback Periods, and Incremental Earnings

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Fast Track Bikes is thinking of developing a new composite road bike. Development will take six years and the cost is \$200,000 per year. Once in production, the bike is expected to make \$300,000 per year for 10 years.

1. Assuming the cost of capital is 10%, calculate the NPV of this investment opportunity. Should the company make the investment?

2. Assuming the cost of capital is 10%, calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

3. Assuming the cost of capital is 10%, how long must development last to change the decision?

4. Assuming the cost of capital is 14%, calculate the NPV of this investment opportunity. Should the company make the investment?

5. Assuming the cost of capital is 14%, how much must this cost of capital estimate deviate to change the decision? What is the maximum cost of estimate deviation allowable before change decision?

6. Assuming the cost of capital is 14%, how long must development last to change the decision?

7. You are considering making a movie. The movie is expected to cost \$10 million upfront and take a year to make. After that, it is expected to make \$5 million in the year it is released and \$2 million for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%? If payback period of two years, will you make the movie?

8. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in Georgia and South Carolina. Management is contemplating building an eight retail store across town from its most successful retain outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month the marketing department spent \$10,000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store.

Which of the following should be included as part of the incremental earnings for the proposed new retail store

a. The cost of the land where the store will be located
b. The cost of demolishing the abandoned warehouse and clearing the lot
c. The loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead
d. The \$10,000 in market research spent to evaluate customer demand
e. Construction cost for the new store
f. The value of the land if sold
g. Interest expense on the debt borrowed to pay the construction cost.

Select either yes or no for the scenarios.

#### Solution Preview

See the attached Excel sheet for the calculations.
1. Assuming the cost of capital is 10%, calculate the NPV of this investment opportunity. Should the company make the investment?

NPV: \$186,430.47
Yes, the company should make the investment if the cost of capital is 10%.

2. Assuming the cost of capital is 10%, calculate the IRR and use it to determine the maximum deviation allowable in the cost of capital estimate to leave the decision unchanged.

IRR: 12.66%
Given that cost of capital is 12.66%, the cost of capital for the first 6 years of the project should not be more than \$158,986 to still arrive at the same net present value computed in Problem 1 (\$186,430.47). Moreover, given that the project has a cost of capital of 10%, to still arrive at the same decision, make the investment, the cost of capital for the first 6 ...

#### Solution Summary

This response determines whether various companies should make new investments.

\$2.19