Brandon Pizzas Inc operates pizza shops in several states, one of its pizza restaurant has an opportunity to expand by leasing space in an adjacent building. The lease would be $18,000 per year under a 15 years lease contract. Jaco management is considering 2 ways in which the available space can be used.

Alternative 1

The pizza shop in this location is currently selling 40,000 pizzas per year. Management is confident that sales could be increased by 75% by taking out the wall between the pizza shop and the vacant space and expanding the pizza outlet. Costs for remodelling and for new equipment would be $550,000. Management estimates that 20% of the new sales would be small pizzas, 50% would be medium pizzas, and 30% for the large pizzas. Selling prices and costs for ingredients for the 3 sizes pizzas follow (per pizza).

Small selling price $6.70 and cost of ingredients $1.30

Medium selling price $8.90 and cost of ingredients $2.40

Large selling price $11.00 and cost of ingredients $3.10

An additional $7500 of working capital would be needed to carry the larger volume of business. This working capital would be released at the end of the lease term. The equipment would have a salvage value of $30,000 in 15 years, when the lease ended.

Alternative 2

Brandon's sales manager feels that the company needs to diversify its operations. He has suggested that an opening be cut in the wall between the pizza shop and the vacant space and that video games be placed in the space, along with a small snack bar. Costs for remodelling and for the snack bar facilities would be $290,000. The games would be leased from a large distributor of such equipment. The distributor has stated that based on the use of game centers elsewhere, Jaco could expect about 26,000 people to use the center each year and to spend an average of $5 each on the machines. In addition it is estimated that the snack bar would provide a net cash inflow of $15,000 per year. An investment of $4000 in working capital would be needed to provide change funds and to provide inventory for the snack bar. This working capital investment would be released at the end of the lease term. The snack bar equipment would have a salvage value of about $12,000 in 15 years.

Brandon management is unsure which alternative to select and has asked you to help in making a decision. You have gathered the following information relating to added costs that would be incurred each year under the 2 alternatives:

IF you expand the pizza shop

Rent building space $18,000

Salaries $54,000

Utilities $13,200

Insurance and other $7800

If you install the game center

Rent building space $18,000

Rent video games $30,000

Salaries $17,000

Utilities $5,400

Insurance and other $9600

1. Compute the expected net annual cash inflows from each alternative (10 points)
2. Assume that the cost of capital is 16%. Compute the NPV of each alternative. Which alternative would you recommend? (40 points)
3. Calculate the IRR of each alternative. (10 points)
4. How would taxes affect your NPV for each alternative assuming 40% taxes and straight-line depreciation. (RECALCULATE BOTH with taxes) (20 points)
5. Assume that the company decides to accept alternative 2 At the end of the first year the company finds that only 21,000 people used the game center during the year ( each person spent $5 on the games) Also the snack bar provided a net cash inflow of only $13,000. In light of this information, does it appear that the game center will provide the company's 16% required rate of return? Show computations to support your answer.(20 points)