You have just completed your undergraduate degree, and one of your favorite cour
ID: 2722842 • Letter: Y
Question
You 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.
Questions:
Net Present Value (NPV) (Worth 10 points)
Define the term net present value (NPV).
What is each franchise's NPV? Make sure to show the formula, steps and final answer.
Based on your answer which franchise would you select? Why?
Would your answer be different if the projects are independent or mutually exclusive? Why or why not?
Would the NPVs change, and therefore your answer, if the cost of capital changed? Why or why not?
Internal Rate of Return (IRR) – you may use a financial calculator or excel.(Worth 8 points)
What is the logic/idea behind the IRR method?
Calculate the IRR for each project. Make sure to show the formula, calculator or excel steps and final answer.
According to IRR, which franchise should be accepted if they are independent? Mutually exclusive? Why?
Would the franchises' IRRs change if the cost of capital changed? Why or why not?
Modified Internal Rate of Return (MIRR) (Worth 6 points)
Define the term modified IRR (MIRR).
Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final answer.
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?
Payback and Discounted Payback Period (Worth 10 points)
What is the rationale for the payback method?
Calculate the payback period for each franchise. Make sure to show the formula, steps and final answer.
Calculate the discounted payback period for each franchise. Make sure to show the formula, steps and final answer.
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?
What is the difference between the regular and discounted payback periods? Make sure to mention the advantage and disadvantage of each.
This question is worth 16 points.
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
Net present value:
Formula for net present value= Present value of cash inflows- Present value of cash outflows.
Net present value is the difference between present value of cash inflows minus present value of cash outflows. If funds are available both the projects can be taken up as the NPV of the projects is positive.
If the projects are mutually exclusive, then Franchise S is preferred to Franchise L because NPV of Franchise S is more than that of Franchise L.
If the cost of capital changes, then the NPV of the projects would change, because the present value is arrived by multiplying the cash flows with present value factor which inturn is dependent on the Cost of capital or the required rate of return.
Internal rate of return:
Internal rate of return is the rate at which if the cash flows are discounted then NPV is zero.
Using Exce formula IRR(range of cells havings cash inflows and outflows) the following is calculated:
Basing on IRR Franchise S and Franchise L are to be accepted as the IRR is more than the required rate of return.If the projects are independent then both the projects can be taken up and if both the projects are mutually exclusive then Franchise S is to be opted.
If the cost of capital changes then IRR would not change.Because IRR is dependent on the cash flows and the duration of the project and does not depend on the cost of capital.
Year Franchise S Franchise L Present value factor @10% Franchise S Franchise L 0 -100 -100 1 -100 -100 1 70 10 0.909091 63.63636364 9.090909091 2 50 60 0.826446 41.32231405 49.58677686 3 20 80 0.751315 15.02629602 60.10518407 Total 19.9849737 18.78287002Related Questions
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