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Serpents Den You have just graduated from the MBA program of a large university, and one of your favorite TV programs was "Serpents Den." 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 $1, 500,000 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) in Brampton. 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 PP: Peters Pierogis and (2) Franchise SS: Sadhils Samosas. 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 SS's cash flows will start off slowly but will increase rather quickly as word of mouth spreads, while Franchise PP's cash flows will start off high but will trail off as people become more health conscious and avoid gluten. Franchise PP serves Mon to Thurs, while Franchise SS serves Fri-Sun so it is possible for you to invest in both franchises. Here are the net cash flows (in thousands of dollars):

	Expected Net Cash Flow
Year	Franchise PP	Franchise SS
0	($150)	($150)
1	105	15
2	75	90
3	30	120

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.

1. What is capital budgeting? 2. What is the difference between independent and mutually exclusive projects? 3. Describe the capital work order life cycle. What principal of natural justice is at work here? 4. Define the term net present value (NPV). What is each franchise's NPV? 5. What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive? 6. Would the NPVs change if the cost of capital changed? What would they be if WACC was 12%? Explain. 7. Define the term internal rate of return (IRR). What is each franchise's IRR? 8. How is the IRR on a project related to the YTM on a bond? 9. What is the logic behind the IRR method? According to IRR, which franchise should be accepted if they are independent? Mutually exclusive? 10. Would the franchises' IRRs change if the cost of capital changed? 11. Calculate NPV profiles (0 to 24% in 2% increments) for Franchises PP and SS. At what discount rate do the profiles cross? 12. Look at your NPV profile graph without referring to the actual NPVs and IRRs. 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 the cross-over rate? 13. (i) What is the underlying cause of ranking conflicts between NPV and IRR? (ii) What is the "reinvestment rate assumption," and how does it affect the NPV versus IRR conflict? 14. Which method is the best? Why? 15. (i) Define the term modified IRR (MIRR). Find the MIRRs for Franchise PP and SS. (ii) 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? 16. As a separate project (Project JJ Janes Jams), you are considering sponsoring a pavilion at the upcoming World's Fair. The pavilion would cost $1,200,000, and it is expected to result in $7.5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $7.5 million of costs, to demolish the site and return it to its original condition. Thus, Project JJ's expected net cash flows look like this (in millions of dollars): The project is estimated to be of average risk, so its cost of capital is 10 percent. 0 1 2

-1,200,000 7,500,000 (7,500,000)

What are normal and non-normal cash flows?

17. What is Project JJ's NPV? What is its IRR? Its MIRR? 18. Draw Project JJ's NPV profile. Does Project JJ have normal or non-normal cash flows? Should this project be accepted? 19. What does the profitability index (PI) measure? What are the PI's for Franchises SS and PP? 20. What is the payback period? Find the paybacks for Franchises SS and PP. 21. What is the rationale for the payback method? 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 SS and PP are independent? If they are mutually exclusive? 22. What is the difference between the regular and discounted payback periods? 23. What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions? Page 4 of 4 24. In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects; the projects provide a necessary service, so whichever one is selected is expected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital. Project L WACC: 10.0% Year 0 1 2 3 4

End of Period ($100) $33.5 $33.5 $33.5 $33.5 Project S WACC: 10.0% Year 0 1 2 3 4

End of period ($100) $60 $60

What is each projects initial NPV without replication? 25. What is each projects equivalent annual annuity? Which is indicated choice? 26. You are also considering another project which has a physical life of 3 years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have a positive salvage value. Here are the projects estimated cash flows:

Year	Operating CAsh Flow	Salvage Value
0	($5,000)	$5,000
1	2100	3100
2	2000	2000
3	1750	0

The cost of capital is 10%. If the asset is operated for the entire three years of its life, what is its NPV? 27. Would the NPV change if the company planned to terminate the project at the end of Year 2? 28. At the end of Year 1? 29. What is the projects optimal (economic) life? 30. After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra-large capital budget cause?

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