You have just completed your undergraduate degree, 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 program, your grandfather died and left you $300,000 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 three years. After three years you 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 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 three-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, while 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):
￼net cash flows
year ￼￼Franchise Franchise
￼￼0 (100) (100)
￼￼￼￼￼￼￼￼1 70 10
￼￼￼￼￼￼￼￼￼￼￼￼￼￼2 50 60
￼￼￼￼￼￼￼￼￼￼￼3 20 80
￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼￼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 percent. You must now determine whether one or both of the projects should be accepted.
In order to do so please answer the following questions fully. Make sure to show a time line, the formula to be used, the steps taken to solve the problem (calculator or excel) and the final numerical answer when appropriate.
Net Present Value (NPV) (Worth 10 points)
1. Define the term net present value (NPV).
2. What is each franchise’s NPV? Make sure to show the formula, steps and final answer.
3. Based on your answer which franchise would you select? Why?
4. Would your answer be different if the projects are independent or mutually exclusive? Why
or why not?
5. Would the NPVs change, and therefore your answer, if the cost of capital changed? Why or
Internal Rate of Return (IRR) – you may use a financial calculator or excel. (Worth 8 points)
1. What is the logic/idea behind the IRR method?
2. Calculate the IRR for each project. Make sure to show the formula, calculator or excel steps
and final answer.
3. According to IRR, which franchise should be accepted if they are independent? Mutually
4. Would the franchises’ IRRs change if the cost of capital changed? Why or why not?
Modified Internal Rate of Return (MIRR) (Worth 9 points)
1. Define the term modified IRR (MIRR).
2. Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final
3. What are the MIRR’s advantages and disadvantages vis-a-vis the regular IRR? What are the
MIRR’s advantages and disadvantages vis-a-vis the NPV?
Payback and Discounted Payback Period (Worth 10 points)
1. What is the rationale for the payback method?
2. Calculate the payback period for each franchise. Make sure to show the formula, steps and
3. Calculate the discounted payback period for each franchise. Make sure to show the formula,
steps and final answer.
4. According to the payback criterion, which franchise or franchises should be accepted if the
firm’s maximum acceptable payback is 2 years, and if Franchise L and S are independent? If
they are mutually exclusive? Why?
5. What is the difference between the regular and discounted payback periods? Make sure to
mention the advantage and disadvantage of each.
This question is worth 13 points.
Based on the results obtained and everything that you have described above, which franchise would you ultimately choose if the projects are mutually exclusive? Explain in detail your decision and why you chose the model you did to make your final decision.
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