MBA program

You have just graduated from the MBA program of a large university, and one of 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 your time frame is 3 years. After 2 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 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 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 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 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.
a. What is capital budgeting? Are there any similarities between a firm’ capital budgeting decisions and an individual’s investment decisions?
b. What is the difference between independent and mutually exclusive projects? Between normal and nonnormal projects?
c. (1) What is the payback period? Find the paybacks for Franchises L and S.
c. (2) What is the rationale for the payback period? What are its strengths and weaknesses? According to the payback criterion, which franchise or franchises should be accepted if your maximum acceptable payback is two years, and Franchises L and S were independent? Mutually exclusive?
c. (3) What is the difference between the regular payback and the discounted payback?
c. (4) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?
d. (1) Define the net present value (NPV). What is each franchise’s NPV?
d. (2) What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
d. (3) Would the NPVs change if your opportunity cost changed?
e. (1) Define the internal rate of return (IRR). What is each franchise’s IRR?
e. (2) How is the IRR on a project related to the YTM on a bond?
e. (3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?
e. (4) Would the franchises’ IRRs change if your opportunity cost changed?
f. (1) Define the profitability index (PI). What is each franchise’s PI?
f. (2) What is the rationale behind the PI method? According to the PI, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
g. (1) Draw the NPV profiles for Franchises L and S. At what discount rate do the profiles cross?
g. (2) Look at the 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. Do your answers here apply for all discount rates less than 23.6 percent?
h. (1) What is the underlying cause of ranking conflicts between NPV and IRR?
h. (2) Under what conditions can conflicts occur?
h. (3) Which method is best? Why?
I. (1) Define the modified IRR (MIRR). Find the MIRR for Franchises L and S.
i. (2) What are the MIRR’s advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR’s advantages and disadvantages visa-vis the NPV?
j. As a separate and unrelated project, a friend of yours is considering sponsoring a pavilion at an upcoming World’s Fair. The pavilion would cost $400,000, and it is expected to result in $2.5 million of incremental cash inflows during its one year of operation. However, it would then take another year, and $2.5 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):
Year Cash Flow
0 ($0.4)
1 2.5
2 (2.5)
The project is estimated to be of average risk, so its cost of capital is 10 percent.
(1) What is Project P’s NPV? What is its IRR? Its MIRR?
j. (2) Draw Project P’s NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?