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:

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

1. What is each franchise’s NPV? ; Be sure to show your calculations.
2. According to the NPV, which franchise or franchises should be accepted if they are independent? ; Which should be accepted if they are mutually exclusive?
3. Would the NPV change if the cost of capital changed?
4. What is each franchise’s IRR? ; Be sure to show your calculations.
5. What is the logic behind the IRR method? ; According to the IRR, which franchises should be accepted if they are independent? ; Mutually exclusive?
6. Would the franchises’ IRR change if the cost of capital changed?
7. Draw the NPV profiles for each franchise. ; At what discount rate do the profiles cross?
8. 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%?
9. Which method is best and why? ;