Capital

MINI

CASE

You have just graduated from the MBA program of a large university, 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 master's 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 skillwhich 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 yourselection down to two choices (1) Franchise L: Lisa's Soups, Salads, & Stuff and (2) Franchise S: Sam's Wonderful Fried Chicken. The net cash flows shown below include (a) the price you would receive for selling the franchise in Year 3 and (b) 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 aspeople 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 perfectcomplements 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 flow estimates (in thousands of dollars): Expected Net Cash Flow Year Project L Project S 0 ($150) ($150) 1 15 105 2 90 75 3 120 30 Depreciation, net working capital requirements, andtax effects are all included in these cash flows. You also have made subjective risk assessments of each franchise, and you have concluded that both franchises have risk characteristics which are similar to your best alternative investment. You will require a return of 10 percent. You must now determine whether one or both of the projects should be accepted. a. What is capital budgeting? Are thereany similarities between a firm's capital budgeting decisions and an individual's investment decisions? ANSWER: Capital budgeting is the process of analyzing additions to fixed Capital budgeting is important because, more than anything else, assets. 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 are involved:
Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 7 - 13

Ø Estimate the cash flows--interest or dividends in the case of bonds and 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 theriskiness of the flows and the general level of interest rates. This is called the project cost of capital in capital budgeting. Ø Find (a) the PV of the expected cash flows and/or (b) the asset's rate of return. Ø If the PV of the inflows is greater than the PV of the outflows (the NPV is positive), or if the calculated rate of return (the IRR) is higher than the project cost of capital, accept theproject.

b.

What is projects?

the difference between independent and Between normal and nonnormal projects?

mutually

exclusive

ANSWER: Projects are independent if the cash flows of one are not affected by the acceptance of the other. Conversely, two projects are mutually exclusive if acceptance of one impacts adversely the cash flows of the other; for example, a forklift truck...