ou have just completed your undergraduate degree, and one of your favorite cours
ID: 2722439 • Letter: O
Question
ou have just completed your undergraduate degree, and one of your 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 program, your grandfather died and left you $300,000 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 that your time frame is three years. After three years you will sell off your investment and 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 three-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, while Franchise S serves only dinner, so it is possible for you to invest in 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 flows
Year
Franchise S
Franchise L
0
($100)
($100)
1
70
10
2
50
60
3
20
80
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 percent. You must now determine whether one or both of the projects should be accepted.
In order to do so please answer the following questions fully. Make sure to show a time line, the formula to be used, the steps taken to solve the problem (calculator or excel) and the final numerical answer when appropriate.
1. Would the franchises' IRRs change if the cost of capital changed? Why or why not?
2. Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final answer.
3. According to the 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? Why?
4. Based on the results obtained and everything that you have described above, which franchise would you ultimately choose if the projects are mutually exclusive? Explain in detail your decision and why you chose the model you did to make your final decision.
Expected
net cash flows
Year
Franchise S
Franchise L
0
($100)
($100)
1
70
10
2
50
60
3
20
80
Explanation / Answer
1. IRR reveals the rate of return, the project will be yielding. It doesn't have anything to do with cost of capital. So, the change in cost of capital will not change IRR.
2. MIRR = [(Future Value of all positive cash flows)/(initial Outlay)]1/2 - 1
Franchise L: {[(10*1.10)+(60*1.102)+(80*1.103)]/100}1/2 - 1 = 37.87%
Franchise S: {[(70*1.10)+(50*1.102)+(20*1.103)]/100}1/2 - 1 = 28.11%
3. Payback for Franchise S:
Amount recovered in Year 1 = $70
Amount to be recovered = $100 - $70 = $30
Payback Period = 1 +($30/$50) = 1.6 Years
Payback for Franchise L:
Amount recovered in Year 1 & 2 = $10 + $60 = $70
Amount to be recovered = $100 - $70 = $30
Payback Period = 2 +($30/$80) = 2.375 Years
So, Payback Period suggests, if the franchise are independent, both can be accepted as it will recover the initial outlay before the end of project. If projects are mutually exclusive, project with shorter payback period should be accepted, which is Franchise S.
4. Based on above results, we should choose Franchise L based on MIRR. The MIRR suggest the overall return of the project and as Franchise L has higher MIRR, it will result in highest profit.
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