Mod 6 Mini Case
A. To start off, Capital Budgeting is the process of planning which is utilized to determine and understand whether a company or a firm’s long term investment would be worth pursuing. Long term investments include purchasing new machinery, replacement materials, new plants, new products, and the research and development projects. In this case, the long term investments mentioned are the fast food franchises, whether it is worth pursuing two franchises or not.
B. Independent and Mutually Exclusive Projects – Independent projects are those wherein the cash flows of one project is not affected by that of another project. On the other hand, mutually exclusive projects are those whose cash flows can be adversely affected by the acceptance of the other project. Franchise L and Franchise S could be independent projects if the accept/reject decision (in the aspect of pursuing the other franchise) doesn’t have any impact on the other franchise. They are mutually exclusive if the acceptance of one franchise may have consequences upon the decision of the other franchise. Because the two franchises would be owned by only one person, with a limited budget of a million dollars, it is possible that the two are mutually exclusive projects, as the performance of the other franchise may affect another, despite the fact that they don’t directly compete with each other.
C. 1. Payback Period – The payback period in business would refer to the time frame needed in order to have return of investment in order to repay for the sum of the initial investment. If the cash flows are the same for the time of the whole project, then the formula would be Payback period = Investment/Cash flow. But in the case of the two franchises where the benefits change over time, then the formula would be Payback period = 1(last year with a negative cash flow) + [absolute value of net benefits/total cash flow of the following year].
For Franchise L, the computation would be:
Payback period = 1 + [100/70] => 2.4 years payback period
For Franchise S, the computations would be:
Payback period = 1 + [100/120] => 1.8 years payback period.
C. 2. Basing on the method of the payback period, the franchise with the shorter payback is the one preferable. In this case, the franchise that should be accepted would be franchise S, as it has the shorter payback period which coincides with the acceptable payback of 2 years, if the two franchises are independent of projects. But if they are mutually exclusive, they did not qualify for the acceptable payback because they have a 2.05 years payback period.
C. 3. A regular payback period always ignores the cash flow beyond the time it takes for the payback, as it also does not consider the time value of the money. It is used to identify the risk and liquidity of a certain project, in this case of the franchises. On the other hand, discounted payback period method is similar with the regular payback method, except for the fact that it discounts the cash flow based on the firm’s cost of capital, and it also considers the time value of money in the project. Their similarity is that they ignore the cash flows outside the time of payback.
C. 4. The main disadvantage of a discounted payback is that it takes a little more time to actually cover a payback period because it discounts the first year cash flow when it is not enough to cover the initial investment. It takes a longer time to reach a payback than the actual payback period. The method of the payback period is a useful tool for investment decisions, because it serves as a basis for comparison for decisions especially when it comes to time constraints. However, it should not be used in isolation because it does not properly account other important factors like the time value of money, the risk, financing and other important matters like opportunity cost. This could be a basis though it is better to use other methods to come up with investment decisions.
D. 1. Net Present Value – the NPV is a standard method for financial appraisal of long term projects, specifically used for capital budgeting and other concerns throughout economics. It measures the excess or the shortfall of cash flows in terms of the PV or the present value as soon as financing charges are met. It is the present worth of the net cash flows for a certain project, or in this case, for the franchises. The NPV for franchise L is 18.783 at 10% discount rate. For franchise S, the NPV at 10% discount rate is 19.984.
D. 2. The NPV method is used as an indicator of how much an investment or a project brings value to a company or firm. For mutually exclusive projects, the one that yields the higher NPV is of greater value, so it should be the one selected. This means that franchise S should be the one established. In the case of independent projects, as long as there is a positive NPV, then it is acceptable. In this case, both franchises passed.
D. 3. The NPV would change if the cost of capital is changed because it will be the basis of the discount rate of the NPV.
E. 1. Internal rate of return – The IRR is a capital budgeting metric which is used to decide if they are to make investments, as it indicates the efficiency of an investment, compared to that of the NPV which is the value or the magnitude. The Internal rate of return of the franchise L is 0.76529 or 76.529% while for the franchise S, the internal rate of return is .76459 or 76.459%.
E. 2. The IRR of a project is related to the yield to maturity of a bond because it serves as a basis for deciding whether or not to invest in that project. Consequently, the yield to maturity is the yield promised by the bondholder which should be achieved at a certain point in time. It measures the rate of return for the bond.
E. 3. Based on the IRR method, a project is seen as a good investment when the IRR is greater than the rate of return by an alternate investment, so in a mutually exclusive case, the franchise with the higher IRR is definitely the better choice. In this case, the franchise L has a greater IRR than that of the franchise S, so it is the better choice based on the IRR method. As for Independent projects, if there is greater than the project’s cost of capital, then it would surely add value for the company.
E. 4. The IRRs would surely change if the cost of capital changes because it is part of the initial computation. With a different value, then the outcome would also be different.