Reference no: EM132501728

IRR and NPV with Performance Evaluation Conflict Pepperoni Pizza Company owns and operates fast-service pizza parlors throughout North America. The firm operates on a regional basis and provides almost complete autonomy to the manager of each region. Regional managers are responsible for long-range planning, capital expenditures, personnel policies, pricing, and so forth. Each year the performance of regional managers is evaluated by determining the accounting return on fixed assets in their regions; a return of 14 percent is expected.

• To determine this return, regional net income is divided by the book value of fixed assets at the start of the year. Managers of regions earning a return of more than 16 percent are identified for possible promotion, and managers of regions with a return of less than 12 percent are subject to replacement. Mr. Light, with a degree in hotel and restaurant management, is the manager of the Northeast re- gion. He is regarded as a "rising star" and will be considered for promotion during the next two years. Light has been with Pepperoni for a total of three years. During that period, the return on fixed assets in his region (the oldest in the firm) has increased dramatically. He is currently considering a proposal to open five new parlors in the Boston area. The total project involves an investment of $650,000 and will double the number of Pepperoni pizzas sold in the Northeast region to a total of 600,000 per year. At an average price of $6 each, total sales revenue will be $3,600,000. The expenses of operating each of the new parlors include variable costs of $4 per pizza and fixed costs (excluding depreciation) of $80,000 per year. Because each of the new parlors has only a five-year life and no salvage value, yearly straight-line depreciation will be $26,000 [($650,000 - 5 parlors) = 5 years).

Required

Question a) Evaluate the desirability of the $650,000 investment in the new pizza parlors by computing the internal rate of return and the net present value. Assume a 14% discount rate. If you wish to use present value tables (instead of EXCEL), refer to Appendix 12-B for tables.

Question b) If Light is shrewd, will he approve the expansion? Why or why not? You may wish to do some additional calculations.