Mini Case 2 You have just graduated from the MBA program of a large of a large u
ID: 2771185 • Letter: M
Question
Mini Case 2 You have just graduated from the MBA program of a large of a large university, and one of your favorite course was “Todays 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 pleased. 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 possible). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is3 years. After 3 years you will 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 flow shown below include the price you would receive for selling the franchise in year 3 and the forecast flow 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 bother franchises. You see these franchise 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 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 franchise have risk characteristics that require a return of 10. You must now determine whether one or both of the franchises should be accepted. a. What is capital Budgeting? b. What is the difference between independent and mutually exclusive projects? c. (1) Define the term net present value (NPV). What is each franchise’s NPV? (2) What is the rationale behind the NPV method? According to NPV, which franchise or franchise should be accepted if they are independent? Mutually exclusive (3) Would the NPV’s change if the cost of capital changed?
Explanation / Answer
Part a)
Capital budgeting is mainly concerned with the evaluation of investment proposals proposed to be undertaken by the company. The process of capital budgeting involves use of various techniques like NPV (net present value, internal rate of return, etc.) which help in identifying the feasibility of a particular project. Cash outflows and cash inflows expected from the project are analyzed, evaluated and a decision is finally made as to the acceptance or rejection of an investment proposal.
Capital budgeting is frequently used to evaluate projects which involve significant investment/outlay. Without capital budgeting, wrong projects may be accepted which may affect the overall financial stability and sustainability of the company. Capital budgeting, when used appropriately, can help in identifying projects that can improve the cash flow position of the company and contribute in increasing the wealth of company's stakeholders.
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Part b)
The basic difference between independent and mutually exclusive projects is that the acceptance of a mutually exclusive project will have an impact on (the cash flows) another project, whereas, there will be no such impact in case of an independent project. To state otherwise, mutually exclusive projects cannot be accepted by the company at the same time (either of the projects available has to be selected). On the other hand, multiple independent projects can be selected and performed at the same time.
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Part c)
1) NPV is the difference between present value of cash inflows and cash outlows expected to be generated from a project. The present value is calculated by discounting the cash flows from the project to arrive at today's value with the use of a discount rate. The formula for calculating NPV is:
NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Discount Rate)^1 + Cash Flow Year 3/(1+Discount Rate)^2 + Cash Flow Year 3/(1+Discount Rate)^3
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NPV (Franchise L) = -100 + 10/(1+10%)^1 + 60/(1+10%)^2 + 80/(1+10%)^3 = $18.78
NPV (Franchise S) = -100 + 70/(1+10%)^1 + 50/(1+10%)^2 + 20/(1+10%)^3 = $19.98
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2) The rationale behind calculating NPV is that the project with a positive and higher NPV should be selected. NPV is considered as one of the best capital budgeting techniques for project evaluation and selection. Projects with positive NPV indicate excess of cash inflows over cash outflows and are generally selected by the company subject to budget constraints.
According to NPV method, both the Franchise can be accepted (since both produce positive NPV), if projects are independent (but the decision is subject to availability of funds).
According to NPV method, Franchise S should be selected (as it produces higher NPV), if projects are mutually exclusive.
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3) Yes, the NPV would change if the cost if capital is changed. It has an inverse relationship with the cost of capital, that is, NPV would increase if cost of capital decreases and vice versa.