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Homework answers / question archive / It is 2022 and CompuTech has decided to expand its business

It is 2022 and CompuTech has decided to expand its business

Finance

It is 2022 and CompuTech has decided to expand its business. They have the choice of taking out a competitor in their community and expanding their market presence or they can open a second business which is a franchise opportunity.

In the first option the takeover cost would be $300,000 and would result in net cash flow of $60,000 per year beginning in the second year of ownership. No net cash flow is expected in the first year as takeover expenses would offset any proceeds. It is estimated that the business begin acquired could have a residual value of $200,000 in the 10th year.

This second option involves franchising at a cost of $75,000 per year with the potential to bring in $100,000 of net profits in each year, beginning in year 2. No proceeds are forecast in year 1. The franchise would run for only 8 years.

Q1: If the CompuTech cost of capital is 7% which of the options available to the Martins would you recommend? Remember to do a NPV calculation, a Payback calculation, and an IRR calculation to support your answer.

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In the given problem we need to take a decision between two alternatives

a) Computation of NPV, IRR, Payback period in Option 1

Year 0 -300000 1 -300000  
Year 1 0 0.935 0 -300000
Year2 60000 0.816 48960 -240000
Year3 60000 0.763 45780 -180000
Year 4 60000 0.713 42780 -120000
Year 5 60000 0.666 39960 -60000
Year 6 60000 0.623 37380 0
Year 7 60000 0.582 34920 60000
Year 8 60000 0.544 32640 120000
Year 9 60000 0.508 30480 180000
Year 10 60000 0.475 28500 240000
Year 10 200000 0.475 95000 440000
Toatl     436400 440000
         
NPV     572800 Payback =Year 6
IRR     6%  

b) Computation of NPV, IRR, Payback period in Option 2

Year 0 -75000 1 -75000 -7500
Year 1 0 0.935 0 -75000
Year 2 100000 0.816 81600 25000
Year 3 100000 0.763 76300 125000
Year 4 100000 0.713 71300 225000
Year 5 100000 0.666 66600 325000
Year 6 100000 0.623 62300 425000
Year 7 100000 0.582 58200 525000
Year 8 100000 0.544 54400 625000
         
         
NPV     395700 Payback -Year 2
IRR     60%  

Though Option 2 has shorter Payback period & a higher IRR yet NPV of Option 1 is higher than Option 2 & hence Option 1 should be preferred over Option 2