Copyright 1996 by The Dryden Press. All rights reserved.
Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 7 – 13You have just graduated from the MBA program of a large university, and one ofyour favorite courses was “Today’s Entrepreneurs.” In fact, you enjoyed it somuch you have decided you want to “be your own boss.” While you were in themaster’s program your grandfather died and left you $300,000 to do with as youplease. You are not an inventor, and you do not have a trade skill which youcan market; however, you have decided that you would like to purchase at leastone 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 toolong, so you figure that your time frame is three years. After three yearsyou will sell off your investment and 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 Wonderful FriedChicken. The net cash flows shown below include (a) the price you wouldreceive for selling the franchise in Year 3 and (b) the forecast of how eachfranchise will do over the three-year period. Franchise L’s cash flows willstart off slowly but will increase rather quickly as people become more healthconscious, while Franchise S’s cash flows will start off high but will trailoff as other chicken competitors enter the marketplace and as people becomemore health conscious and avoid fried foods. Franchise L serves breakfast andlunch, while Franchise S serves only dinner, so it is possible for you toinvest in both franchises. You see these franchises as perfect complements toone another: you could attract both the lunch and dinner crowds and thehealth conscious and not so health conscious crowds without the franchisesdirectly competing against one another.Here are the net cash flow estimates (in thousands of dollars):Expected Net Cash FlowYear Project L Project S0 ($150) ($150)1 15 1052 90 753 120 30Depreciation, net working capital requirements, and tax effects are allincluded in these cash flows.You also have made subjective risk assessments of each franchise, andyou have concluded that both franchises have risk characteristics which aresimilar to your best alternative investment. You will require a return of 10percent. You must now determine whether one or both of the projects should beaccepted.a. What is capital budgeting? Are there any similarities between a firm’scapital budgeting decisions and an individual’s investment decisions?ANSWER: Capital budgeting is the process of analyzing additions to fixedassets. Capital budgeting is important because, more than anything else,fixed asset investment decisions chart a company’s course for the future.Conceptually, the capital budgeting process is identical to the decisionprocess used by individuals making investment decisions. These steps areinvolved:Ø Estimate the cash flows–interest or dividends in the case of bondsand stocks, operating cash flows in the case of capital projects.Ø Assess the riskiness of the cash flows.Ø Determine the appropriate discount rate, based on the riskiness of theflows and the general level of interest rates. This is called theproject cost of capital in capital budgeting.Ø Find (a) the PV of the expected cash flows and/or (b) the asset’s rateof return.Ø If the PV of the inflows is greater than the PV of the outflows (theNPV is positive), or if the calculated rate of return (the IRR) ishigher than the project cost of capital, accept the project.b. What is the difference between independent and mutually exclusiveprojects? Between normal and nonnormal projects?ANSWER: Projects are independent if the cash flows of one are not affected bythe acceptance of the other. Conversely, two projects are mutually exclusiveif acceptance of one impacts adversely the cash flows of the other; forexample, a forklift truck versus a conveyor system to move materials, or abridge versus a ferry boat.Normal projects have outflows, or costs, in the first year (or years)followed by a series of inflows. Nonnormal projects have one or more outflowsafter the inflow stream has begun. Here are some examples:Inflow (+) or Outflow (-) in Year0 1 2 3 4 5Normal – + + + + +- – + + + +- – – + + +Nonnormal – + + + + — + + – + -+ + + – – -c. (1) What is the payback period? Find the paybacks for Franchises L andS.ANSWER: The payback period is the expected number of years required to recovera project’s cost. We calculate the payback by developing the cumulative cashflows as shown below for Franchise L (in thousands of dollars):Expected Net Cash FlowsYear Annual Cumulative0 ($150) ($150)1 15 (135)2 90 (45)Payback is between3 120 75×—— t = 2 and t = 30 1 2 3-150 15 90 120-135 -45 +75Franchise L’s $150 investment has not been recovered at the end of Year 2, but