You Have Just Graduated From The MBA Program Of A Large Univ

You Have Just Graduated From The MBA Program Of A Large University An

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 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 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. Here are the net cash flows (in thousands of dollars): Expected Net Cash Flows Year Franchise L Franchise S Depreciation, salvage values, net working capital requirements, and tax effects are all included. 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.

Paper For Above instruction

Capital budgeting is a fundamental financial management process that involves evaluating and selecting long-term investments that are in line with a firm's strategic objectives. It encompasses the analysis of potential projects or investments to determine their value and assess whether they will generate adequate returns over time. Essential aspects include estimating future cash flows, assessing risk, and choosing projects that maximize the company's value. Techniques such as net present value (NPV), internal rate of return (IRR), and payback period are used to aid decision-making, ensuring that resources are allocated efficiently to projects that contribute most significantly to shareholder wealth.

Understanding the difference between independent and mutually exclusive projects is crucial in capital budgeting. Independent projects are those where the acceptance of one does not affect the decision regarding others; each is evaluated on its own merits. Conversely, mutually exclusive projects are competing alternatives where choosing one precludes selecting the other(s). For example, a company deciding whether to purchase Project A or Project B faces a mutually exclusive situation; selecting one excludes the other. This distinction influences the evaluation criteria and decision rules applied.

Net present value (NPV) is a key metric used in capital budgeting to measure the profitability of an investment. Defined as the difference between the present value of cash inflows and outflows, NPV accounts for the time value of money by discounting future cash flows at the project’s required rate of return or cost of capital. For Franchise L, assuming cash flows of \$X, and for Franchise S, cash flows of \$Y, NPV calculations involve discounting these cash flows over the 3-year horizon at 10%. The rationale behind the NPV method is that it quantifies how much value a project adds to the firm; positive NPVs indicate value creation, making the project acceptable. If the NPVs are positive and the projects are independent, both should be accepted. If they are mutually exclusive, the project with the higher NPV is preferred. NPVs are sensitive to the discount rate; changing the cost of capital will alter the NPVs accordingly.

Internal rate of return (IRR) is the discount rate that makes the net present value of a project's cash flows equal to zero. It indicates the expected percentage return on the invested capital. For each franchise, IRRs are calculated by solving the cash flow equations for the discount rate that sets NPV to zero. The IRR on a project is related to the yield to maturity (YTM) of a bond, as both measure the rate of return earned over the respective period. The IRR method hinges on the assumption that intermediate cash flows can be reinvested at the IRR, which can sometimes lead to conflicting rankings compared to NPV. For independent projects, any IRR above the required return suggests acceptance, whereas for mutually exclusive projects, the one with the higher IRR may not always have the higher NPV, especially when cash flow patterns are non-conventional.

NPV profiles graph the relationship between the NPV of a project and varying discount rates. By plotting NPVs at different rates, one can observe the crossover point where the profiles intersect—the discount rate at which the NPVs of the two franchises are equal. If the profiles show that at discount rates below the crossover, one project is superior, and above it, another project dominates, investors can make informed decisions based on their required rate of return. For example, if the crossover rate is 23.6%, and the company’s cost of capital is less than this, the decision might favor the project with the higher NPV at that rate. The graphical analysis enables assessment of project acceptability under different discount rate scenarios and reveals potential ranking conflicts between NPV and IRR.

The ranking conflicts between NPV and IRR occur primarily due to differences in how these metrics handle cash flow timing, magnitude, and project scale. IRR can sometimes give multiple or misleading signals with non-conventional cash flows or mutually exclusive projects because it assumes reinvestment at the IRR rate and may not reflect the actual value created. NPV, focusing on absolute value, consistently aligns with shareholder wealth maximization. When projects vary significantly in size or cash flow patterns, IRR may suggest an advantage for a less valuable project, leading to ranking conflicts.

Modified internal rate of return (MIRR) addresses some IRR limitations by assuming reinvestment at the firm’s cost of capital rather than the IRR, producing a unique and more realistic measure of a project’s profitability. MIRRs are calculated by discounting cash inflows at the cost of capital, then compounding the terminal value. For Franchises L and S, the MIRRs might differ from IRRs and often provide a more reliable basis for project comparison, especially when cash flows are non-conventional or there are multiple IRRs.

The profitability index (PI) measures the ratio of the present value of future cash inflows to the initial investment. A PI greater than 1 indicates that the project's discounted cash inflows exceed the initial outlay, signaling acceptability. For example, if Franchise S has a PI of 1.2 and Franchise L has 1.1, both add value, but S is relatively more attractive. PI is particularly useful when capital constraints exist, allowing prioritization of projects that provide the greatest return per dollar invested.

The payback period is the time required for a project to recover its initial investment through cash inflows. For Franchise L and S, calculations involve summing incremental cash flows until the initial investment is recovered. If the maximum acceptable payback is 2 years, and the paybacks for Franchises L and S are within this limit, they are acceptable; otherwise, they are rejected. The method's rationale is its simplicity and focus on liquidity and risk reduction. However, it ignores the time value of money unless discounted payback is used. Discounted payback accounts for the time value of money but can still be biased towards shorter-term projects. Its main disadvantage is ignoring cash flows after the payback period, potentially missing valuable long-term benefits, rendering it less effective for comprehensive capital budgeting decisions.

In addition to franchise evaluation, a separate project considerations involve assessing the financial viability of sponsoring an exhibition pavilion at the World’s Fair. This project has a significant upfront cost and a substantial immediate cash inflow, followed by a period of demolition costs. The cash flows are non-conventional because of the large initial and final cash flows, making it a nonnormal project. Calculating NPV involves discounting all cash flows at 10%, providing guidance on project acceptability. The IRR and MIRR further support decision-making. If the NPV is positive and the IRR exceeds the cost of capital, the project should be accepted. Graphically, the NPV profile would demonstrate the nonnormal nature, crossing the x-axis twice, indicating multiple IRRs. Consequently, MIRR is often more reliable for nonnormal projects.

Furthermore, analyzing two mutually exclusive projects, T and F, with differing durations involves calculating NPVs, converting to equivalent annual annuities, and applying chain replacement methods. These approaches enable comparison over comparable periods, revealing which project offers better long-term value. When inflation raises costs for project T, the analysis must be adjusted to reflect the increased initial capital outlay, possibly altering the optimal choice depending on the updated NPVs and IRRs. If the revised cost of replication exceeds the original, the project’s attractiveness diminishes, and the alternative project may become preferable.

Lastly, evaluating a project with a limited lifespan and salvage value involves calculating the NPV over the planned duration, considering salvage proceeds. The project's optimal (economic) life maximizes net benefits, balancing operational cash flows against salvage value and costs. Early termination periods can significantly impact NPV, potentially making shorter planning horizons more or less favorable depending on cash flow patterns and salvage realizations. Determining the optimal life involves analyzing cash flow models that include salvage and choosing the period where incremental returns are maximized.

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