Jays portion A to D

Chapter 10 Mini Case

Jerathen Tillman 11/5/2011

A. What is capital budgeting? a. Capital budgeting is the decision , concept, and understanding to include or analyze projects into capital budgeting based on five key methods used to evaluate projects for capital budgeting. Such methods are: (1) Payback period, (2) discount payback period, (3) net present value, (4) internal rate of return, and (5) modified internal rate of return. The following methods are use by financial analysts to determine the cost analysis and risk versus reward ratio for investing in an investment project.

B. What is the difference between independent and mutually exclusive projects a. Simply put, independent projects are not affected by cash flows of other outstanding projects while mutually exclusive projects are affected and one of the projects must be rejected (Page 348) C. Define a. Net Present Value i. Is used as a tool or method to examine the effectiveness of a project by understanding and considering discounted cash flow techniques. Finding the NPV, involves finding the present value of project; if cash flows are positive then the project should be considered for acceptance and if the cash flows are negative the project should be rejected it (Page 349).

b. What is each franchises NPV? i.

NPV(S) =

$19.98

= Sum disc. CF's.

Franchise L Time period: Cash flow: Disc. cash flow: NPV(L) = $18.78

0 -100 -100

1 10 9

2 60 50

3 80 60

c. What is the rationale behind the NPV method?

i.

The NPV method suggests that all independent that have positive NPV should be accepted. Accepting positive NPV asserts that positive cash flow consist and wealth, profit maximization, and increases shareholders wealth are why the NPV methods are being used to evaluate if this a good investment decision. A mutually exclusive project seeks to identify the project with the most value and possibility to increase wealth or maximize profits (Project with highest NPV).

d. According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive ? i. If both projects are independent accept both (Look at excel for more details) ii. If projects are mutually exclusive accept on Project S (Look at excel for more details ) e. Would the NPVs change if the cost of capital changed i. Yes, depending on the size of the capital budgeting and the perception of investors. Normal or usually size of capital budgeting would dictate where the NPV would be positive or negative. D. Define a. Internal Rate of Return i. Discount rate that equates the PV of a projects expected cash inflows to the PV of the cost or equivalently. This is when the IRR rate forces NPV to equal zero (Pg .351).

b. What us each franchises IRR i.

Expected net cash flows Franchise S Franchise L ($100) ($100) 70 10 50 60 20 80

Year (t) 0 1 2 3

IRR IRR

S L

= =

23.56% 18.13%

c. How is the IRR on a project related to the YTM on a bond

i.

By investing in a bond and holding to maturity, investor will receive all cash flows or YTM. Same concepts apply to IRR in capital budgeting as discount rate equates to PV of a projects expected cash inflows compared to cost (Pg.351)

ii.
3 40 IRR = Similarity to a bond: 0 -1,134 1 90 IRR = 2 90 7.08% 3 90 4 90 5 90 6 90 9.70%

d. What is the logic behind the IRR method? i. IRR = expected rate of return ii. If IRR exceeds cost, surplus will remain and additional wealth filter to firms stockholders iii. Thus taking on projects where IRR exceed cost usually means we are increasing wealth of shareholders and maximizing profits (Pg. 352)

Reference:

Brigham, Eugene F., Michael C. Ehrhardt. Financial Management. 11th ed. Mason, Ohio: South Western, 2005.