The cost, useful life and disposal value of the two BBQ grilling machines B1 and B2 are as follows:

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1 Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum Course 1: Contemporary Perspectives on Accounting Unit 10: Capital Investment Appraisal Learning Resources Corner The Takee BBQ Case Takee BBQ is a recently set-up BBQ food take-out chain stores in Hong Kong and PRC. Currently it has five stores and opens 12 hours a day. It locates near a residential traffic spot so people can purchase the food and bring home for lunch or dinner. Despite there is a worry that people will rather cook the food at home than to buy ready made food, the founder Peter Chu believes that people in Hong Kong will be getting more busy to work than to stay home to cook, so the business will grow in times. Peter intends to set up 20 chain stores in two years time. One of the most intensive capital investments is the BBQ grilling machines invented by Peter himself which is specially designed to make different kinds of delicious food. Most of parts are imported from the USA. Each store has at least four BBQ machines. The largest one has eight BBQ machines. Peter has registered the patent rights of these machines. Basically there are two models, one cost $80,000 and the other cost $100,000 to manufacture. Peter will invest to make these machines based on the sales demand and return generated from each machine. The cost, useful life and disposal value of the two BBQ grilling machines B1 and B2 are as follows: Grilling machine Cost Useful life Disposal value B1 $80,000 4 years $8,000 B2 $100,000 4 years $4,000 1 of 7 Learning Resources Corner

2 Estimated profits before depreciation generated by these two machines are as follows: Grilling machine B1 B2 Year 1 $85,000 $80,000 Year 2 $90,000 $104,000 Year 3 $97,000 $108,000 Year 4 $100,000 $108,000 Peter is able to obtain a bank loan to purchase the machines at around 5% to 7 % interest rate per annum depending on the financial market situation. Peter has performed the following capital investment analysis on the BBQ grilling machines: 1. Accounting rate of return (ARR) 2. Payback period (PB) and discounted payback period (DPB) 3. Net present value (NPV) assuming the cost of financing is: (i) 5%; and (ii) 7% 4. Set up the NPV profiles of the two machines and locate the crossover rate. 1. Accounting rate of return (ARR) analysis Yr 1 Yr 2 Yr 3 Yr 4 Average B1 $ $ $ $ $ Profit before depreciation 85,000 90,000 97, ,000 93,000 Less: Depreciation 18,000 18,000 18,000 _18,000 18,000 Profit after depreciation 67,000 72,000 79,000 82,000 75,000 Cost 80,000 80,000 80,000 80,000 80,000 Less: Accumulated depreciation _18,000 _36,000 _54,000 _72,000 _45,000 Net book value 62,000 44,000 26,000 8,000 35,000 ARR of B1 = $75,000 / $35,000 x 100% = 214% Yr 1 Yr 2 Yr 3 Yr 4 Average B2 $ $ $ $ $ Profit before depreciation 80, , , , ,000 Less: Depreciation _24,000 _24,000 _24,000 _24,000 _24,000 Profit after depreciation 56,000 80,000 84,000 84,000 76,000 2 of 7 Learning Resources Corner

3 Cost 100, , , , ,000 Less: Accumulated depreciation _24,000 _48,000 _72,000 _96,000 _60,000 Net book value 76,000 52,000 28,000 4,000 40,000 ARR of B2 = $76,000 / $40,000 x 100% = 190% Analysis: B1 has a far better return (214%) than B2 (190%). 2. Payback period (PB) and Discounted payback period (DPB) analysis PB of B1 = $80,000 / $85,000 = 0.94 years PB of B2 = 1 year + ($100,000 $80,000) / $104,000 = 1.25 years DPB of B1 = $80,000 / $80,952 = 0.99 years DPB of B2 = 1 year + ($100,000 $76,190) /$ 94,331 = 1.25 years 3. Net present value (NPV) analysis (i) NPV - discounted at 5% B1 $ $ Yr 0 Purchase cost (80,000) 1 (80,000) Yr 1 85,000 1/(1+5%) 1 80,952 Yr 2 90,000 1/(1+5%) 2 81,633 Yr 3 97,000 1/(1+5%) 3 83,792 Yr 4 100,000 1/(1+5%) 4 82,270 Yr 4 Disposal 8,000 1/(1+5%) 4 6,582 NPV = 255,229 B2 $ $ Yr 0 Purchase cost (100,000) 1 (100,000) Yr 1 80,000 1/(1+5%) 1 76,190 Yr 2 104,000 1/(1+5%) 2 94,331 Yr 3 108,000 1/(1+5%) 3 93,294 Yr 4 108,000 1/(1+5%) 4 88,852 Yr 4 Disposal 4,000 1/(1+5%) 4 3,291 NPV = 255,958 3 of 7 Learning Resources Corner

4 (ii) NPV - Discounted at 7% B1 $ $ Yr 0 Purchase cost (80,000) 1 (80,000) Yr 1 85,000 1/(1+7%) 1 79,439 Yr 2 90,000 1/(1+7%) 2 78,609 Yr 3 97,000 1/(1+7%)3 79,181 Yr 4 100,000 1/(1+7%) 4 76,290 Yr 4 Disposal 8,000 1/(1+7%) 4 6,103 NPV = 239,622 B2 $ $ Yr 0 Purchase cost (100,000) 1 (100,000) Yr 1 80,000 1/(1+7%) 1 74,766 Yr 2 104,000 1/(1+7%) 2 90,838 Yr 3 108,000 1/(1+7%) 3 88,160 Yr 4 108,000 1/(1+7%) 4 82,393 Yr 4 Disposal 4,000 1/(1+7%) 4 3,052 NPV = 239,209 At 5% interest rate of financing: NPV of B1 ($255,229) < NPV of B2 ($255,958) At 7% interest rate of financing: NPV of B1 ($239,622) > NPV of B2 ($239,209) There is a ranking conflict. 4 of 7 Learning Resources Corner

5 4. Net present values (NPV) profiles analysis Using an excel table to calculate the NPV for the two BBQ grilling machines: Interest rate (%) NPV B1 Interest rate (%) NPV B2 $ $ 0 300, , , , , , NPV profiles for B1 and B2 NPV ($) 304, ,000 Crossover rate 245,101 B2 B Cost of capital (%) If interest rate of financing is greater than the crossover rate (6.28%), B1 is better. If interest rate of financing is less than the crossover rate (6.28%), B2 is better. Required: (a) Comment on the above capital investment analyses. (b) Suggest how to solve the ranking conflict by formulating a selection strategy for the BBQ grilling machines. 5 of 7 Learning Resources Corner

6 Suggested Solution to the Takee BBQ Case: (a) ARR and PB are simple to calculate and understand. However both methods ignore the borrowing costs. DPB is an important indicator of risk to recover capital investment. However, it fails to take into account the cash flows after the payback period. NPV is a better analytical tool here since it considers the time value of money and the interest rate of financing. However, there may exist ranking conflict which need to be solved. IRR is an important indicator of the return required for the project over time. However, it does not indicate the amount of earnings. (b) The ranking conflict of the BBQ grilling machines exists if the interest rate of borrowing is less than the crossover rate (6.28%), B2 is preferred; if greater than 6.28%, B1 is preferred. If the interest rate of borrowing is 6.28%, B1 is preferred because the IRR of B1is greater than B2. Also B1 has better ARR, PB and DPB. --End of the Case-- 6 of 7 Learning Resources Corner

7 Additional Readings & References 1. Keown, A. J., Martin, J. D., Petty, W. and Scott, D. (2005), Financial Management, Florida: Pearson, Prentice Hall, 10th Edition, Chapter 9 Capital budgeting decision criteria, modified IRR, pp (ISBN ) 2. Lucey, T. (2003), Management Accounting, London, Continuum, 5th Edition, Chapter 18, Inflation affects investment appraisal and effects of capital rationing and possible project selection, pp , (ISBN ) 7 of 7 Learning Resources Corner