You have just graduated from the MBA program of a large university, 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 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 that your time frame is 3 years. After 3 years you will go on to something else.
You have narrowed your selection down to two choices:
Franchise L, Lisa’s Soups, Salads & Stuff, and
Franchise S, Sam’s Fabulous Fried Chicken.
The net cash flows that follow 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 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 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.
What is capital budgeting?
What is the difference between independent and mutually exclusive projects?
What is the underlying cause of ranking conflicts between NPV and IRR?
Define the term “modified IRR (MIRR).” Find the MIRRs for Franchises L and S.
What does the profitability index (PI) measure? What are the PIs of Franchises S and L?
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):
The project is estimated to be of average risk, so its cost of capital is 10%.
In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects, Project T (which lasts for 2 years) and Project F (which lasts for 4 years):
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.
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 project’s estimated cash flows:
Using the 10% cost of capital, what is the project’s NPV if it is operated for the full 3 years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of Year 1? What is the project’s optimal (economic) life?
| Year | Initial Investment and Operating Cash Flows | End-of-Year Net Salvage Value |
|---|---|---|
| 0 | −$5,000 | $5,000 |
| 1 | 2,100 | 3,100 |
| 2 | 2,000 | 2,000 |
| 3 | 1,750 | 0 |
What is each project’s initial NPV without replication?
What is each project’s equivalent annual annuity?
Apply the replacement chain approach to determine the projects’ extended NPVs. Which project should be chosen?
Assume that the cost to replicate Project T in 2 years will increase to $105,000 due to inflation. How should the analysis be handled now, and which project should be chosen?
| Expected Net Cash Flows | ||
|---|---|---|
| Year | Project T | Project F |
| 0 | −$100,000 | −$100,000 |
| 1 | 60,000 | 33,500 |
| 2 | 60,000 | 33,500 |
| 3 | — | 33,500 |
| 4 | — | 33,500 |
What are normal and nonnormal cash flows?
What is Project P’s NPV? What is its IRR? Its MIRR?
Draw Project P’s NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?
| Year | Net Cash Flows |
|---|---|
| 0 | −$0.8 |
| 1 | 5.0 |
| 2 | −5.0 |
What is the payback period? Find the paybacks for Franchises L and S.
What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be accepted if the firm’s maximum acceptable payback is 2 years and if Franchises L and S are independent? If they are mutually exclusive?
What is the difference between the regular and discounted payback periods?
What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?
Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?
Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6%?
Define the term “internal rate of return (IRR).” What is each franchise’s IRR?
How is the IRR on a project related to the YTM on a bond? For example, suppose the initial cost of a project is $100 and it has cash flows of $40 each year at Years 1, 2, and 3. What is its IRR? Use the Excel RATE function as though the project were a bond.
What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?
Would the franchises’ IRRs change if the cost of capital changed?
Define the term “net present value (NPV).” What is each franchise’s NPV?
What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
Would the NPVs change if the cost of capital changed?
Prompt:
Work through the questions at the end of the case by analyzing the data and performing all needed calculations.
You are a business broker and you need to advise clients about the investment in a business, in this case a franchise.
Prepare a PowerPoint presentation with speaker’s notes or narration on the analysis of these investments using capital budgeting techniques:
Notes on creating a presentation:
Subtitle: A Business Broker’s Guide
Your Name
Date
Slide 1: Introduction
Briefly introduce the scenario: You have just graduated from an MBA program and have received a $1 million inheritance. You want to invest in one or two fast-food franchises.
Mention the two franchise options: Franchise L (Lisa’s Soups, Salads & Stuff) and Franchise S (Sam’s Fabulous Fried Chicken).
Highlight the importance of using capital budgeting techniques to make an informed investment decision.
Slide 2: What is Capital Budgeting?
Define capital budgeting as the process of evaluating and selecting long-term investment projects.
Explain that it involves analyzing cash flows, risk assessments, and comparing investment options.
Slide 3: Independent vs. Mutually Exclusive Projects
Define independent projects as those where the acceptance of one project does not affect the acceptance of another.
Define mutually exclusive projects as those where only one project can be selected among competing options.
Slide 4: Ranking Conflicts between NPV and IRR
Explain that ranking conflicts can occur when different projects are evaluated using Net Present Value (NPV) and Internal Rate of Return (IRR).
Mention that the underlying cause is the timing and magnitude of cash flows.
Slide 5: Modified IRR (MIRR)
Define Modified IRR (MIRR) as an alternative method that addresses some of the shortcomings of IRR.
Explain that MIRR considers reinvestment rates and is more reliable for ranking projects.
Calculate and display the MIRRs for Franchise L and Franchise S.
Slide 6: Profitability Index (PI)
Define Profitability Index (PI) as a measure of how much value an investment creates for every dollar invested.
Explain that PI is calculated as the present value of cash flows divided by the initial investment.
Slide 7: Project P – World’s Fair Pavilion
Present Project P, which involves sponsoring a pavilion at the World’s Fair.
Discuss the project’s initial investment, cash inflows, and demolition costs.
Calculate and display Project P’s NPV, IRR, and MIRR.
Slide 8: Project T and Project F
Introduce Project T and Project F as mutually exclusive projects with different durations.
Calculate and display the initial NPVs of both projects.
Slide 9: Replication and Optimal Economic Life
Discuss the concept of replication and how it affects project analysis.
Calculate and display the equivalent annual annuity for both projects.
Slide 10: Replacement Chain Approach
Explain the replacement chain approach and how it helps in selecting projects with different durations.
Apply the approach to determine the extended NPVs of Project T and Project F.
Slide 11: Inflation Adjustment
Discuss how inflation can impact project analysis.
Mention the increased replication cost for Project T due to inflation.
Explain how this should be considered in the analysis.
Slide 12: Normal vs. Nonnormal Cash Flows
Define normal cash flows as those with alternating signs (positive and negative).
Define nonnormal cash flows as those with multiple changes in direction.
Identify the cash flow patterns of Franchise L and Franchise S.
Slide 13: NPV Profiles
Present NPV profiles for Franchise L and Franchise S.
Identify the discount rate at which the profiles cross.
Slide 14: Payback Period
Define the payback period as the time it takes to recover the initial investment.
Calculate and display the payback periods for Franchise L and Franchise S.
Discuss the rationale behind the payback method.
Slide 15: Discounted Payback
Explain the difference between regular and discounted payback periods.
Mention the main disadvantage of discounted payback.
Discuss the usefulness of the payback method in capital budgeting decisions.
Slide 16: IRR (Internal Rate of Return)
Define IRR as the discount rate that makes the NPV of a project equal to zero.
Calculate and display the IRRs for Franchise L and Franchise S.
Slide 17: NPV (Net Present Value)
Define NPV as the difference between the present value of cash inflows and the initial investment.
Calculate and display the NPVs for Franchise L and Franchise S.
Explain the rationale behind the NPV method.
Slide 18: Sensitivity to Cost of Capital
Discuss how changes in the cost of capital can impact project NPVs and IRRs.
Mention that NPVs and IRRs should be re-evaluated if the cost of capital changes.
Slide 19: Conclusion
Summarize the key points discussed in the presentation.
Emphasize the importance of using capital budgeting techniques for informed investment decisions.
Slide 20: Recommendations
Provide recommendations for the investment in Franchise L, Franchise S, Project P, Project T, and Project F based on the analysis.
Consider whether they are independent or mutually exclusive.
Slide 21: References
List all references for images and sources used in the presentation.
Slide 22: Q&A
Open the floor for questions and discussion.
Note: In the speaker’s notes or narration, provide detailed explanations and calculations for each slide to guide the audience through the analysis.
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