Expected Net Cash Flows Year Franchise L Franchise S 0 ($120) ($120) 1 20 90 2 7

Question

Expected Net Cash Flows

Year Franchise L Franchise S

0 ($120) ($120)

1 20 90 2 70 15

3 85 60

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 14%. You must now determine whether one or both of the franchises should be accepted.

9. 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 12%?

10. What is the underlying cause of ranking conflicts between NPV and IRR?

11. What does the profitability index (PI) measure? What are the PI’s for Franchises S and L?

12. 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?

Explanation / Answer

Pay Back Period=

Evaluation of investment proposal (net present value method) Year Cash Flow PVF@14% Present Value of Cash Flow L S L S 0 -120 -120                1.000                (120.00)                     (120.00) 1 20 90                0.877                    17.54                         78.95 2 70 15                0.769                    53.86                         11.54 3 85 60                0.675                    57.37                         40.50 Net Present Value                      8.78                         10.99 Yes , both the Franchise can be accepted as they are showing positive NPV Calculation of Internal Rate of Return Project L Project S NPV @14%                            8.78 NPV @14%                         10.99 NPV @17%                          14.16 NPV @20% 0.14 NPV @18%                          (1.04) NPV @21% -1.51 Interpolution between 17% and 18% Interpolution between 20% and 21% IRR = 17 % + 1.30 /(1.30+1.04) IRR = 20 % + 0.14 /(0.14+1.51) = 17.56% = 20.08% 9 Both project are acceptable if they are independent as they have IRR above the 14% cost of capital line. We will accept project S if both are mutualyy exclusive due to high rate on IRR. Our answer will be same even Cost of Capital less than 12 % because NPV at this level also 14.16 and 15.02 for project L&S respectively. 10 The drawback of IRR is as it is expressed in terms of percentage regardless of the size of the investment, however, the NPV is preferred for both mutually and independent projects, if the projects are mutually exclusive the project with higher NPV is selected regardless of its size of investment, but if they are indedendend then the NPV Index is used, the preference is given to projects with higher NPV indes. Under the IRR it is assumed that the investment is made at the rate of IRR, while under NPV the rate of investment is used as the cost of capital.    The NPV is preferred for both mutually and independent projects, if the projects are mutually exclusive the project with higher NPV is selected regardless of its size of investment, but if they are indedendend then the NPV Index is used, the preference is given to projects with higher NPV indes. 11 Profitability index is used where two projects have different amount of investment to be made, it helps in ranking the project. The company will put all money which has the higher PI.   Calculation of Profitability Index (PI) PI = PV of inflows / PV of outflows Project L PI = 128.78/120=           1.07 Project S PI = 130.99/120=           1.09 12 Payback period tells in how many years the initial investment will be recovered. Year Cash Flow Net Cummulative Cash Inflow L S L S 0 -120 -120 -120 -120 1 20 90 -100 -30 2 70 15 -30 -15 3 85 60 55 45

Pay Back Period=

Initial Cash Flow/ Cash Inflow per year Project :-L Pay Back Period= 2+ (30/85)=                   2.35 Project :-S Pay Back Period 2+ (15/60)=                   2.25 Payback is not used to evaluate the project acceptance as it does not consider the cash flow for the whole project. It also does not make difference whether it is mutually exclusive or independent, and no project is acceptable as the target payback period is 2 years and L and S both have payback period more than 2 years.

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