Capital Budgeting Application
You have just graduated and one of your favorite courses was Financial Management. While you were in school, your grandfather died and left you $1 million. You have decided to invest the funds in a fast-food franchise and have two choices–Franchise L and Franchise S. You only intend to be in business for three years and then sell the franchise. See the cash flows for each year below:
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 included in the cash flows. The required rate of return is 10%. You must decide which franchise to invest in.
Procedure
- What is each franchise's NPV? Be sure to show your calculations.
- According to the NPV, which franchise or franchises should be accepted if they are independent? Which should be accepted if they are mutually exclusive?
- Would the NPV change if the cost of capital changed?
- What is each franchise's IRR? Be sure to show your calculations.
- What is the logic behind the IRR method? According to the IRR, which franchises should be accepted if they are independent? Mutually exclusive?
- Would the franchises' IRR change if the cost of capital changed?
- Draw the NPV profiles for each franchise. At what discount rate do the profiles cross?
- Using the NPV profiles above, 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%?
- Which method is best and why?
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