You have just graduated from the MBA program of a largeuniversity, and one of your favorite courses was “Today’sEntrepreneurs.” In fact, you enjoyed it so much you have decidedyou want to “be your own boss.” While you were in the master’sprogram, your grandfather died and left you $1.5 million to do withas you please. You are not an inventor, and you do not have a tradeskill that you can market; however, you have decided that you wouldlike to purchase at least one established franchise in thefast-foods area, maybe two (if profitable). The problem is that youhave never been one to stay with any project for too long, so youfigure that your time frame is 3 years. After 3 years you will goon 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 belowinclude the price you would receive for selling the franchise inYear 3 and the forecast of how each franchise will do over the3-year period. Franchise L’s cash flows will start off slowly butwill increase rather quickly as people become morehealth-conscious, while Franchise S’s cash flows will start offhigh but will trail off as other chicken competitors enter themarketplace and as people become more health-conscious and avoidfried foods. Franchise L serves breakfast and lunch whereasFranchise S serves only dinner, so it is possible for you to investin both franchises. You see these franchises as perfect complementsto one another: You could attract both the lunch and dinner crowdsand the health-conscious and not- so-health-conscious crowdswithout the franchises directly competing against one another.

Here are the net cash flows (in thousands of dollars):

Franchise L:

Year	Group 2
0	-300
1	30
2	200
3	240

Franchise S:

Year	Group 2
0	-300
1	210
2	150
3	30

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 franchiseand concluded that both franchises have risk characteristics thatrequire a return of 12.5%. You must now determine whether one orboth of the franchises should be accepted.

a.         (1) Define theterm net present value (NPV). What is each franchise’s NPV?

(2) According to NPV, which franchiseor franchises should be accepted if they are independent? Mutuallyexclusive?

(3) Would the NPVs change if the cost of capital changed to10%?

b.         (1) Define theterm internal rate of return (IRR). What is each franchise’sIRR?

(2) What is the logic behind the IRRmethod? According to IRR, which franchises should be accepted ifthey are independent? Mutually exclusive?

(3) Would the franchises’ IRRs change if the cost of capitalchanged to 10%?

c.        (1) Draw NPV profilesfor Franchises L and S. At what discount rate do the profilescross?

(2) Look at your NPV profile graphwithout referring to the actual NPVs and IRRs. Which franchise orfranchises should be accepted if they are independent? Mutuallyexclusive? Explain. Are your answers correct at any cost of capitalless than 23.6%?

d.         Define theterm modified IRR (MIRR). Find the MIRRs for Franchises L andS.

e.         What does theprofitability index (PI) measure? What are the PIs of Franchises Sand L?

f.          (1) What isthe payback period? Find the paybacks for Franchises L and S.

(2) According to the paybackcriterion, which franchise or franchises should be accepted if thefirm’s maximum acceptable payback is 2 years and if Franchises Land S are independent? If they are mutually exclusive?

(3) What is the discounted payback periods for Franchise L andS?

g.        In an unrelatedanalysis, you have the opportunity to choose between the followingtwo mutually exclusive projects, Project T (which lasts for 2years) and Project F (which lasts for 4 years):

Expected Net Cash Flows:

Project T:

Year	Group 2
0	-250000
1	160,000
2	160,000

Project F:

Year	Group 2
0	-250,000
1	87,500
2	87,500
3	87,500
4	87,500

The projects provide a necessary service, so whichever one isselected is expected to be repeated into the foreseeable future.Both projects have a 10% cost of capital.

(1) What is each project’s initial NPV without replication?

(2) What is each project’s equivalent annual annuity?

(3) Apply the replacement chainapproach to determine the projects’ extended NPVs. Which projectshould be chosen?

(4) Assume that the cost to replicateProject T in 2 years will increase by 5% due to inflation. Howshould the analysis be handled now, and which project should bechosen?