FIN609 Case Study - Capital Budgeting Evaluating Cash Flows

Case study (FIN609A

Case Study -1  (Franchise) - Capital Budgeting: Evaluating Cash Flows

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 $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 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 & Stuff, and

(2) Franchise S, Sam’s Fabulous Fried Chicken.

The net cash flows that follow 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 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.

Below are the net cash flows (in thousands of dollars):

                                  Expected Net Cash Flows

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? 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 franchises should be accepted if they are independent? Mutually exclusive?

(3) Would the NPVs change if the cost of capital changed?

d. (1) Define the term “internal rate of return (IRR).” What is each franchise’s IRR?

(2) How is the IRR on a project related to the YTM on a bond? For example, suppose the initial cost of a project is $100 and it has cash flows of $40 each year at Years 1, 2, and 3. What is its IRR? Use the Excel RATE function as though the project were a bond.

(3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?

(4) Would the franchises’ IRRs change if the cost of capital changed?

e. (1) Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?

(2) 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 23.6%?

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

g. Define the term “modified IRR (MIRR).” Find the MIRRs for Franchises L and S.

 h. What does the profitability index (PI) measure? What are the PIs of Franchises S and L?

i. (1) What is the payback period? Find the paybacks for Franchises L and S.

(2) 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?

(3) What is the difference between the regular and discounted payback periods?

(4) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?

j. As a separate project (Project P), you are considering sponsorship of a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its single year of operation.

However, it would then take another year and $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                             Net Cash Flows

0                                                                      - $0.8

1                                                                            5.0

2                                                                          - 5.0

The project is estimated to be of average risk, so its cost of capital is 10%.

(1) What are normal and nonnormal cash flows?

(2) What is Project P’s NPV? What is its IRR? Its MIRR? (3) Draw Project P’s NPV profile. Does Project P have normal or nonnormal cash flows? Should this project be accepted?

 Question 2 : Case Study 2 –  (New Project Analysis)

The Campbell Company is considering adding a robotic paint sprayer to its production line. The sprayer’s base price is $920,000, and it would cost another $20,000 to install it. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $500,000. The MACRS rates for the first three years are 0.3333, 0.4445, and 0.1481. The machine would require an increase in net working capital (inventory) of $15,500. The sprayer would not change revenues, but it is expected to save the firm $304,000 per year in before-tax operating costs, mainly labor. Campbell’s marginal tax rate is 25%.

a. What is the Year-0 cash flow?

b. What are the cash flows in Years 1, 2, and 3?

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of working capital)?

d. If the project’s cost of capital is 12%, what is the NPV?