You have just graduated from the MBA program of a large university, and one of favorite
courses was "Today's Entrepreneurs." In fact, you enjoyed it so much you have decided you want
to "be your own boss." While you were in the master's program, your grandfather died and left
you $1 million to do with as you please. You are not an inventor, and you do not have a trade
skill that you can market; however , you have decided that you would like to purchase at least
one established franchise in the fast-foods area, maybe two (if profitable). The problem is that
you have never been one to stay with any project for too long, so you figure your time frame is 3
years. After 2 years you will go on to something else.
You have narrowed your selection down to two choices: (1) Franchise L, Lisa's Soups, Salads, &
Stuff, and (2) Franchise S, Sam's Fabulous Fried Chicken. The net cash flows shown below
include the price you would receive for selling the franchise in Year 3 and the forecast of how
each franchise will do over the 3-year period. Franchise L's cash flows will start off slowly but
will increase rather quickly as people become more health-conscious, while Franchise S's cash
flows will start off high but will trail off as other chicken competitors enter the marketplace and
as people become more health-conscious and avoid fried foods. Franchise L serves breakfast and
lunch whereas Franchise S serves only dinner, so it is possible for you to invest both franchises.
You see these franchises as perfect complements to one another: You could attract both the lunch
and dinner crowds and the health-conscious and not-so-health-conscious crowds without the
franchises directly competing against one another.
Here are the net Cash flows (in thousands of dollars):
Expected Net Cash Flow
Year Franchise L Franchise S
0 ($100) ($100)
1 10 70
2 60 50
3 80 20
Depreciation, salvage values, net working capital requirements and tax effects are all included in
these cash flows. You also have made subjective risk assessments of each franchise and
concluded that both franchises have risk characteristics that require a return of 10%. You must
now determine whether one or both of the franchises should be accepted.
Year
0
1
2
3
PFIF
1
0.909091
0.826446
0.751315
L
-100
10
60
80
S
-100
70
50
20
NPV
IRR
MIRR
PV L
-100
9.09
49.59
60.11
18.78
18.13%
16.50%
PV S
-100
63.64
41.32
15.03
19.98
23.56%
16.89%
Year
0
1
2
3
PFIF
1
0.909091
0.826446
0.751315
L
-100
10
60
80
PI
S
-100
70
50
20
NPV
IRR
MIRR
PI
Payback
period
1.19
PV L
-100
9.09
49.59
60.11
18.78
18.13%
16.50%
1.19
1.2
PV S
-100
63.64
41.32
15.03
19.98
23.56%
16.89%
1.2
2.375
1.6
Yes both the Franchise can be bought as they are showing positive NPV.
a. What is capital budgeting?
Capital budgeting decision is critical for a company. It may include purchase of fixed assets, construction
of building, factory, etc, one good decision may groom the company and one bad may broom the
company. It is difficult to reverse the capital budgeting decision, once it is taken; therefore, it is
necessary that one should be careful when deciding about the capital budgeting decision. The following
are the key areas to minimize the risk involved in capital budgeting.
a. Evaluation of capital budgeting using various techniques such as accounting rate of return
method, payback period method, net present value method and internal rate of return method.
The most powerful is the net present value method, if projects are mutually exclusive and if not
mutually exclusive, then the deciding factor will be the NPV index.
b. Follow up of completion of capital budgeting. It is necessary that once the paper work is done,
it must be sure that the capital budgeting has been completed within stipulated time period.
For example, if decision about construction of factory has been taken within two years. The
construction process must be followed on regular basis, not at the end of 2 years.
c. Comparison of actual results with planned results if they are achieved then it is said that capital
budgeting is successful.
b. What is the difference between independent and mutually exclusive projects?
When two projects can be undertaken at one time and they are not related to each other , it is
called independent, but when company can opt for only one project out of two or many and they
are related to each other, it is called mutually exclusive.
d. (1) Define the term net present value. What is each franchises NPV?
The net present value is the difference between present value of inflows and outflows
over the life of the project.
(2) What is the rationale behind the NPV method? According to NPV, which franchise or
franchises should be accepted if they are independent? Mutually exclusive?
It helps in knowing whether the present value of future cash flows are equal to the
investment which is made today, if the present value of the future cash flows is less than
initial investment, it is worthless to invest. If both projects are independent, then both
should be accepted as they both have positive NPV, but if they are mutually exclusive,
then the Franchise S should be preferred due to its higher NPV.
(3) Would the NPVs change if the cost of capital changed?
Yes, if the cost of capital goes up, the NPV will go down and vice versa.
e. (1) Define the term internal rate of return (IRR). What is each franchise's IRR?
The rate of return at which the NPV is zero. If the IRR is bigger than the cost of capital,
it means that the project will have positive NPV, otherwise not.
(2) How is the IRR on a project related to the YTM on a bond?
(3) What is the logic behind the IRR method? According to IRR, which franchises should
be accepted if they are independent? Mutually exclusive?
(4) Would the franchises' IRR change if the cost of capital changed?
f. (1) Draw NVP profiles for Franchises L and S. At what discount rate do do the profiles
cross?
30
25
20
15
10
5
Cost
L
(2) Look at your NPV profile graph without referring to the actual NPV's and IRR's. Which
Franchise or franchises should be accepted if they are independant? Mutually exclusive?
Explain. Are your answers correct at any cost of capital less than 23.6%
Both project are acceptable if they are independent as they are above the 10% cost of capital line,
however, if the cost of capital is more than 18.13%, the L will be in negative. Therefore if the
cost of capital is more than 18.13% but less than 23.6%, the project S should be preferred.
g. (1)What is the underlying cause of ranking, conflicts between NPV and IRR?
The drawback of IRR is as it is expressed in terms of percentage regardless of the size of
the investment, however, the NPV is preferred for both mutually and independent
projects, if the projects are mutually exclusive the project with higher NPV is selected
regardless of its size of investment, but if they are indedendend then the NPV Index is
used, the preference is given to projects with higher NPV indes.
(2) What is the reinvestment rate assumption, and now does it affect the NPV - versus IRR conflict?
Under the IRR it is assumed that the investment is made at the rate of IRR, while under
NPV the rate of investment is used as the cost of capital.
(3) Which method is best? Why?
The NPV is preferred for both mutually and independent projects, if the projects are
mutually exclusive the project with higher NPV is selected regardless of its size of
investment, but if they are indedendend then the NPV Index is used, the preference is
given to projects with higher NPV indes.
h. (1)Define the term Modified IRR(MIRR). Find the MIRRs for Franchises L and S.
Only difference in the IRR and the MIRR is the reinvestment rate, under MIRR it is
assuded that the rate of reinvestment is the cost of capital.
(2) What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the
MIRR's advantages and disadvantages vis-a-vis the NPV.
The MIRR gives a better picture due to its use of cost of capital as reinvestment rate. Therefore
the MIRR is always smaller than IRR. However, the best method is NPV for decision making as
discussed earler.
i. What does the profitability index (PI)measure? What are PIs of S and L.
Profitability index is used where two projects have different amount of investment to be
made, it helps in ranking the project. The company will put all money which has the
higher PI.
j. (1) What is the payback period? Find the paybacks for Franchise L and S.
Payback period tells in how many years the initial investment will be recovered.
(2) What is the rationale for the payback method? According to payback criterion, which
franchise or franchises should be accepted if the firm's maximum acceptable payback is 2
years and if Franchise L and S are independent? If they are mutually exclusive?
Payback is not used to evaluate the project acceptance as it does not consider the cash
flow for the whole project. It also does not make difference whether it is mutually
exclusive or independent, only the S is acceptable as the target payback period is 2 years
and S payback period is 1.6 years.
(3) What is the difference between the regular and discounted payback periods?
In the regular payback period the future cash flow are used while under the discounted
payback period, the present value of future cash flows are used.
(4) What is the main disadvantage of discounted payback? Is the payback method of any
real usefulness in capital budgeting decisions?
Due to its disability to cover the future cash flow for the whole life of the project, it is not
used for the evaluation of capital budgeting.
k. As a separate project (Project P), you are considering sponsorship of a pavilion at the
upcoming World's Fair. The pavilion would cost $800,000 and it is expected to result in
$5 million of incremental cash inflows during its single year of operation. However, it
would then take another year, and $5 million of costs, to demolish the site and return it to
its original condition. Thus, Project P's expected net cash flows look like this (in millions
of dollars):
Year Net Cash Flows
0 0 ($0.8)
1 1 5.0
3 2 -5.0
The project is estimated to be of average risk, so its cost of capital is 10%
(1) What are normal and nonnormal cash flows?
The cash flows which is expected in normal course of business is called the normal cash
flows and anything due to unexpected events the cash flow is affected they are called non
normal cash flows.
(2) What is Project P's NPV? What is its IRR?
0
1
1 0.909091
2 0.826446
-0.8
5
-5
NPV
IRR
-0.8
4.545454545
-4.132231405
-0.38677686
can not be calculated
(3) Draw Project P's NPV profile. Does Project P have normal or nonnormal cash flows?
Should this project be accepted.
The profile can be made due to non normal cash flow of negative 5 million in the year 2, the
project is not acceptable due to its negative NPV>
k. In an unrelated analysis, you have the opportunity to choose between the following two
mutually exclusive projects:
Expected Net Cash Flows
Year Franchise L Franchise S
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 --- 33,500
4 --- 33,500
The projects provide a necessary service, so whichever one is selected is expected to be repeated
into the foreseeable future. Both projects have a 10% cost of capital.
(1) What is each projects initial NPV without replication?
Year
PFIF
0
L
S
1 -100000
PV L
PV S
-100000 -100000 -100000
1
2
3
4
0.909091
0.826446
0.751315
0.683013
60000
60000
0
0
NPV
33500 54545.45 30454.55
33500 49586.78 27685.95
33500
0.00 25169.05
33500
0.00 22880.95
4132.23 6190.49
(2) What is each projects equivalent annual annuity?
L 60000
S 33500
(3) No apply the replacement chain approach to determine the projects extended NPVs. Which
project should be chosen?
Year
PFIF
L
S
0
1 -100000
1 0.909091
60000
2 0.826446
60000
3 0.751315
4 0.683013
-40000
60000
-100000
33500
33500
33500
33500
NPV
PV L
-100000
54545.45
49586.78
30052.59
40980.81
15060.45
PV S
-100000
30454.55
27685.95
25169.05
22880.95
6190.49
Franchise L should be chosen.
(4) Now assume the cost to replicate Project S in 2 years will increase to $105,000 because of the
inflationary pressures. How should the analysis be handled now, and which project should be
chosen?
Still the increase in 5000 will make the NPV to 10060.45 which is more than Franchise S,
therefore the decision is unchanged.
l. You are also considering another project that has a physical life of 3 years; that is the
machinery will be totally worn out after 3 years. However, if the project were terminated prior to
the end of 3 years, the machinery would have a positive salvage value. Here are the projects
estimated cash flows:
Year Initial Investment and End-of-Year Net
Operating Cash Flows Salvage Value
Year Initial Investment and Operating Cash flows End of year net Salvage Value
0 ($5,000) ($100,000)
1 2,100 3,100
2 2,000 2,000
3 1,750 0
Using the 10% cost of capital what is the project's NPV if it is operated for the full 3 years?
Year
PFIF
0
1
1 0.909091
2 0.826446
3 0.751315
Optin A
Option B
-5000
2100
2000
1750
-5000
3100
2000
NPV
A
B
-5000
1909.09
1652.89
1314.80
0.00
-123.22
-5000
2818.18
1652.89
0.00
0.00
-528.93
If run for 3 full year it is negative 123.
Would the NPV change if the company planned to terminate the project at the end of Year 2?
Yes it will further increase in terms of negativity to $529
At the end of Year 1? What is the projects optima (economic) life?
It will further increase but the amount cannot be calculated as no data is given. The opimal life
is 3 years with lowest negative NPV.
m. After examining all the potential projects, you discover that there are many more projects this
year with positive NPVs than in a normal year. What tow problems might this extra-large-capital
budget cause.
A
Availability of fund.
B
Ranking of projects.