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Leches operates a chain of sandwich shops

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P21-28A Using payback, rate of return, discounted cash flow models, and
profitability index to make capital investment decisions; Calculating IRR
[30–45 min]

Leches operates a chain of sandwich shops. The company is considering two possible
expansion plans. Plan A would open eight smaller shops at a cost of $8,400,000.
Expected annual net cash inflows are $1,500,000, with zero residual value at the end
of 10 years. Under Plan B, Leches would open three larger shops at a cost of
$8,250,000. This plan is expected to generate net cash inflows of $1,080,000 per year
for 10 years, the estimated useful life of the properties. Estimated residual value for
Plan B is $1,000,000. Leches uses straight-line depreciation and requires an annual
return of 10%.

1. Compute the payback period, the ROR, the NPV, and the profitability index of
these two plans. What are the strengths and weaknesses of these capital budgeting
2. Which expansion plan should Leches choose? Why?
3. Estimate Plan A’s IRR. How does the IRR compare with the company’s required
rate of return?

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