You have just graduated from the MBA program of a large university, and one of y
ID: 2680911 • Letter: Y
Question
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 $1million 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 purcahse 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: 1) Franchise L, Lisa's Soups, Salads and 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 peiople become more health-concious, 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-concious and avoid fried foods. Franchise L serves breakfast and lunch wereas Franchise S serves only dinner, so it is possibly 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-concious and not-so-health concious crowds without the franchises directly competing against one another. Here are the next cash flows (in thousands of dollars)Franchise L Franchise S
Year 0 -100 -100
Year 1 10 70
Year 2 60 50
Year 3 80 20
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. You also have made sbjective risk assessments of each franchise and concluded that both franchises have risk characteristics that require a return of 10%. C. 1.What is each franchise's NPV? 3. Would the NPVs change if the cost of cpital changed? D. 2. How is the IRR on a project related to the YTM on a bond? 3. What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are indepedent? Mututally exclusive? 4. Would the franchises' IRRs change if the cost of cpital changed? F. 1. What is the underlying cause of ranking conflicts between NPV and IRR? g. 1. Find the MIRRs for Franchises L and S. 2. What are the MIRR's advantages and disadvantages vis-a-vis the NPV? h. What are the PI's of Franchise L and S? i. What is the payback period for Franchise L and S? 2. 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 indepedent? If they are mutually excluse? L. 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 the 3 years, the machinery would have a positive salvage value. Here are the project's estimated cash flows
Year Initial Investment and Operating Cash Flows End-of-year net salvage value
0 -5000 5000
1 2100 3100
2 2000 2000
3 1750 0
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?
M. After examining all the potential projects, you discover there are many more projects this year with a positive NPVs than in a normal year. What two porblems might this extra-large capital budget cause?
Explanation / Answer
1. The net present value (NPV) is simply the sum of the present values of a project's cash flows: NPV= CF/(1+r)^n =(10/1.1)+ (60/1.1^2)+(80/1.1^3)- 100 Franchise L'S NPV is $18.79 The NPV of franchise S is NPVS = $19.98. 2.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. 3. IRR measures a project's profitability in the rate of return sense: if a project's IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. An IRR greater than r implies an economic profit, which accrues to the firm's shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn enough to cover its cost of capital. Projects' IRRs are compared to their costs of capital, or hurdle rates. Since franchises L and S both have a hurdle rate of 10 percent, and since both have IRRs greater than that hurdle rate, both should be accepted if they are independent. However, if they are mutually exclusive, franchise S would be selected, because it has the higher IRR. 4. IRRs are independent of the cost of capital. Therefore, neither IRRS nor IRRL would change if r changed. However, the acceptability of the franchises could change--L would be rejected if r were above 18.1%, and S would also be rejected if r were above 23.6%. F. 1. What is the underlying cause of ranking conflicts between NPV and IRR? For normal projects' NPV profiles to cross, one project must have both a higher vertical axis intercept and a steeper slope than the other. A project's vertical axis intercept typically depends on (1) the size of the project and (2) the size and timing pattern of the cash flows--large projects, and ones with large distant cash flows, would generally be expected to have relatively high vertical axis intercepts. The slope of the NPV profile depends entirely on the timing pattern of the cash flows-- long-term projects have steeper NPV profiles than short-term ones. Thus, we conclude that NPV profiles can cross in two situations: (1) when mutually exclusive projects differ in scale (or size) and (2) when the projects' cash flows differ in terms of the timing pattern of their cash flows (as for franchises L and S). g. 1. Find the MIRRs for Franchises L and S. MIRR is that discount rate which equates the present value of the terminal value of the inflows, compounded at the cost of capital, to the present value of the costs. MIRRL = 16.5%. We could calculate MIRRS: =16.9%. Thus, franchise S is ranked higher than L. This result is consistent with theNPV decision. 2. What are the MIRR's advantages and disadvantages vis-a-vis the NPV? MIRR is a better rate of return measure than IRR for two reasons: (1) it correctlyassumes reinvestment at the project's cost of capital rather than at its IRR. (2) MIRRavoids the problem of multiple IRRs--there can be only one MIRR for a given project.MIRR does not always lead to the same decision as NPV when mutuallyexclusive projects are being considered. In particular, small projects often have ahigher MIRR, but a lower NPV, than larger projects. Thus, MIRR is not a perfectsubstitute for NPV, and NPV remains the single best decision rule. However, MIRRis superior to the regular IRR, and if a rate of return measure is needed, MIRR shouldbe used.Business executives agree. As noted in the text, business executives prefer tocompare projects' rates of return to comparing their NPVs. This is an empirical fact.As a result, financial managers are substituting MIRR for IRR in their discussionswith other corporate executives. This fact was brought out in the October 1989 FMAmeetings, where executives from Du Pont, Hershey, and Ameritech, among others, allreported a switch from IRR to MIRR. i. What is the payback period for Franchise L and S? 2. 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 indepedent? If they are mutually excluse? The payback period is the expected number of years required to recover a project'scost. We calculate the payback by developing the cumulative cash flows Franchise L's $100 investment has not been recovered at the end of year 2, but it hasbeen more than recovered by the end of year 3. Thus, the recovery period is between2 and 3 years. If we assume that the cash flows occur evenly over the year, then theinvestment is recovered $30/$80 = 0.375 ˜ 0.4 into year 3. Therefore, paybackL = 2.4years. Similarly, paybackS = 1.6 years. Payback represents a type of "breakeven" analysis: the payback period tells us whenthe project will break even in a cash flow sense. With a required payback of 2 years,franchise S is acceptable, but franchise L is not. Whether the two projects areindependent or mutually exclusive makes no difference in this case. L. 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 the 3 years, the machinery would have a positive salvage value. Here are the project's estimated cash flows Year Initial Investment and Operating Cash Flows End-of-year net salvage value 0 -5000 5000 1 2100 3100 2 2000 2000 3 1750 0 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? No termination: NPV= $-123 Terminate after 2 years: NPV= $ 215 Terminate after 1 year: $-273 We see (1) that the project is acceptable only if operated for 2 years, and (2) that aproject's engineering life does not always equal its economic life. M. After examining all the potential projects, you discover there are many more projects this year with a positive NPVs than in a normal year. What two porblems might this extra-large capital budget cause? You only have a limited amount of capital to commit to projects. If you have to raiseexternal capital to fund some of these other positive NPV projects, then you may befaced with an increasing cost of capital. This is called an increasing marginal cost ofcapital schedule, and it also happens to companies when they exhaust their internalsources of funds and have to go to external capital markets for their finding. Thisincreased cost of capital may cause you to reject projects that you might otherwiseaccept because with your increased cost of capital, some projects may be negativeNPV when they would otherwise be positive NPV in a normal year. Another effect of this large capital budget is that you may choose to ration capital—i.e. not fund all of the projects. This is called capital rationing, and companies andinvestors do this when for whatever reason they put a cap on the funds they arewilling to invest in new projects.
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