Post-Audit and Reevaluation of Investment Proposal: IRR
Throughout his four years in college, Ronald King worked at the local Beef Burger Restaurant in
College City. Although the working conditions were good and the pay was not bad, Ron believed he
could do a much better job of managing the restaurant than the current owner-manager. In particular,
Ron believed that the proper use of marketing campaigns and sales incentives, such as selling a second
burger for a 25 percent discount, could increase annual sales by 40 percent.
Just before graduation in 2016, Ron inherited $500,000 from his great uncle. He seriously con-
sidered buying the restaurant. It seemed like a good idea because he liked the town and its college
atmosphere, knew the business, and always wanted to work for himself. He also knew that the cur-
rent owner wanted to sell the restaurant and retire to Florida. As part of a small business management
course, Ron developed the following income statement for the restaurantâs 2015 operations:
BEEF BURGER RESTAURANT: COLLEGE CITY
Income Statement
For Year Ended December 31, 2015
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450,000
Expenses
Cost of food . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Employee expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000
Property taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Advertising . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
436,000
Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000
Ron believed that the cost of food and supplies were all variable, the employee expenses and utilities
were one-half variable and one-half fixed in 2015, and all other expenses were fixed. If Ron purchased
the restaurant and followed through on his plans, he believed there would be a 40 percent increase
in unit sales volume and all variable costs. Of the fixed costs, only advertising would increase by
$12,000. The use of discounts and special promotions would, however, limit the increase in sales
revenue to only 30 percent even though sales volume increased 40 percent.
Required
a. Determine
1. The current annual net cash inflow.
2. The predicted annual net cash inflow if Ron executes his plans and his assumptions are correct.
b. Ron believes his plan would produce equal net cash inflows during each of the next 15 years, the
period remaining on a long-term lease for the land on which the restaurant is built. At the end of
that time, the restaurant would have to be demolished at a predicted net cost of $80,000. Assum-
ing Ron would otherwise invest the money in stock expected to yield 12 percent, determine the
maximum amount he should pay for the restaurant.
c. Assume that Ron accepts an offer from the current owner to buy the restaurant for $350,000.
Unfortunately, although the expected increase in sales volume does occur, customers make much
more extensive use of the promotions than Ron had anticipated. As a result, total sales revenues are
8 percent below projections. Furthermore, to improve employee attitudes, Ron gave a 10 percent
raise immediately after purchasing the restaurant. Reevaluate the initial decision using the actual
sales revenue and the increase in labor costs, assuming conditions will remain unchanged over the
remaining life of the project. Was the investment decision a wise one? (Round calculations to the
nearest dollar.)
d. Ron can sell the restaurant to a large franchise operator for $250,000. Alternatively, he believes
that additional annual marketing expenditures and changes in promotions costing $20,000 per
year could bring the sales revenues up to their original projections, with no other changes in costs.
Should Ron sell the restaurant or keep it and make the additional expenditures? (Round calcula-
tions to the nearest dollar.) (Hint: Ron has just bought the restaurant.)
