Herb E. Vore is considering investing in a Salad Stop franchise that requires an

Question

Herb E. Vore is considering investing in a Salad Stop franchise that requires an initial outlay of $100,000. He conducted market research and found that after-tax cash flows on this investment should be about $20,000 a year for the next 7 years. The franchiser states that Herb will generate a 20 percent rate of return. Herb currently has his money in a mutual fund, which has grown at an average annual rate of 10 percent. He tells the franchiser that money has a time value, and the actual rate of return according to his calculations is much less than 20 percent rate.

a. Do you agree with the franchiser or with Herb?

b. What rate of return is the franchiser using, and what method did Salad top use to calculate it.

c. What rate of return is Herb using, and what method did he use?

d. Should Herb make the investment? Explain.

Explanation / Answer

I agree with Herb because franchiser is ignoring time value of money and had Herb not invested in this project, his money would have earned 10% in mutual funds

Franchiser is using 20% rate of return and Cash flow/Initial investment to calculate the return

Herb is using mutual fund's return to compare the rate of return. Method used is IRR and the rate of return comes out to be 9.1961%

IRR:

0=-100000+20000/(1+IRR)+20000/(1+IRR)^2.........

Hence, IRR=9.1961%

NPV=-100000+20000/1.1+20000/1.1^2.........

=-2631.62

As NPV is less than 0 and IRR is less than 10%, he should not invest.

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