Response to the following problem:
Java Cafe is considering two possible expansion plans. Plan A is to open 8 Cafés at a cost of $4,180,000. Expected annual net cash inflows are $780,000, with residual value of $820,000 at the end of seven years. Under plan B, Java Café would open 12 cafes at a cost of $4,200,000. This investment is expected to generate net cash inflows of $994,000 each year for seven years, which is the estimated useful life of the properties. Estimated residual value of the plan B cafés is zero. Java Café uses straight-line depreciation and requires an annual return of 14%.
Required
1. Compute the payback period, the accounting rate of return, and the net present value of each plan. Assume a zero residual value when calculating the net present values. What are the strengths and weaknesses of these capital budgeting models?
2. Which expansion plan should Java Cafe adopt? Why?
3. Estimate the internal rate of return (IRR) for plan B. How does plan B's IRR compare with Java Cafe's required rate of return?