Mini Case: You have just graduated from the MBA program of a large university, a
ID: 2736973 • Letter: M
Question
Mini Case:
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 $300,000 to do with as you please. You are not an inventor, and you do not have a trade skill, which 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 Wonderful 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 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 Flow
Year Project L Project S
0 ($150) ($150)
1 15 105
2 90 75
3 120 30
Depreciation, net working capital requirements, and tax effects are all included in these cash flows.
You also have made subjective risk assessments of each franchise’s risk characteristics, and you have concluded that both projects require a return of 10 percent. You must now determine whether one or both of the projects should be accepted.
1) What is each franchise's NPV (net present value)?
2) According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
3) Would the NPVs change if your opportunity cost changed?
4) What is each franchise's IRR (internal rate of return)?
5) How is the IRR on a project related to the YTM on a bond?
6) What is the logic behind the IRR method? According to the IRR, which franchises should be accepted if they are independent? Mututally exclusive?
7) Would the franchises' IRRs change if your opportunity cost changed?
8) What is the underlying cause of ranking conflicts between NPV and IRR?
9) Under what conditions can conflicts occur?
10) Which method is the best? Why?
11) Find the MIRR for franchises L and S
Hey Chegg, I have one problem that needs to be solved, but this one problem consists of 11 questions that needs to be either answered with explanation or solved through mathematics. I would really appreciate if anyone can answer these 11 questions that I have written. Also, please show your work in finding the NPV, IRR, and MIRR for franchise L and S. Include the formula for NPV, IRR, and MIRR and the numbers you used for that formula. I apologize in advance for asking a lot of questions, but I need to solve this problem for a take home final exam. I would really appreciate help. Thanks in advance.
My professor says that the formula for NPV is:
NPV = -cost + NCF [1 - 1/cocn /coc]
Note: NCF is (net cash flow) & coc is (cost of capital)
The formula for IRR is:
NPV = 0 = -cost + NCF [1 - 1 / (1 + IRR)n / IRR]
Please try to use these formulas if you can.
Explanation / Answer
Solution 1:
Project L
NPV = - 150 + 15/1.10 + 90/1.10^2 + 120/1.10^3
NPV = -150 + 13.64 + 74.38 + 90.16
NPV = 28.17
Project S
NPV = - 150 + 105/1.10 + 75/1.10^2 + 30/1.10^3
NPV = -150 + 95.45 + 61.98 + 22.54
NPV = 29.98
Solution 2:
If franchises L and S are independent, then both should be accepted because they both add to the shareholders wealth and hence the stock price. If the franchises are mutually exclusive, then franchise S should be selected over L , because it adds more to the value of the firm.
Solution 3:
NPV of a project depends on the cost of capital. Hence, if the cost of capital is changed, the NPV of each project would change. NPV declines as r increases and NPV rises as r falls.
Solution 4:
IRR is rate of return when NPV = 0
Project L
NPV = - 150 + 15/(1 + IRR) + 90/(1 + IRR)^2 + 120/(1+IRR)^3
0 = -150 + 15/(1 + IRR) + 90/(1 + IRR)^2 + 120/(1+IRR)^3
150 = 15/(1 + IRR) + 90/(1 + IRR)^2 + 120/(1+IRR)^3
Solving for IRR, we get
IRR = 18.13%
Project S
NPV = - 150 + 105/(1 + IRR) + 75/(1 + IRR)^2 + 30/(1+IRR)^3
0 = -150 + 105/(1 + IRR) + 75/(1 + IRR)^2 + 30/(1+IRR)^3
150 = 105/(1 + IRR) + 75/(1 + IRR)^2 + 30/(1+IRR)^3
Solving for IRR, we get
IRR = 23.56%
Solution 5:
The IRR is to a capital project what the YTM is to a bond. It is the expected rate of return on the project, just as the YTM is the promised rate of return on a bond.