Financial Management: Theory and Practice Chapter 10 Minicase

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The Basics of Capitol Budgeting: Evaluating Cash Flows
Mini Case

a. Capital budgeting is the process of analyzing projects and determining which ones to accept and include in the capital budget.

b. Independent projects are ones that can both be accepted without either affecting the other. Mutually exclusive projects are ones that if one is accepted the other must be rejected.


1. The net present value is the projects present value of inflows minus its cost. It shows us how much the project contributes to the shareholders wealth. The NPV of each franchise are: a. NPV of Franchise L – $17.08 (In thousands) b. NPV of Franchise S – $18.17 (In thousands) 2. The rationale behind the NPV method is
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If the franchises are independent they should both be accepted. If they are mutually exclusive Franchise S should be accepted. This because when they are above the required WACC of 10% the NPV is greater than 0, however, when the IRR is greater than the WACC of 10% then NPV of Franchise S is greater the Franchise of L. No, if the cost of capital is 17% or greater then franchise S only should be accepted whether independent or mutually exclusive.

f. 1. The cause to the conflict in the rankings is that while the IRR ranking shows a percentage so that you can see what percentage you are making on certain amount, it does not show the size of the project. 2. The reinvestment rate assumption is the assumption that for the NPV calculation you can reinvest the cash inflows at the WACC and for the IRR calculation you can reinvest the cash flows at the IRR itself. With this assumption you would think that the NPV would be more preferred because the WACC is easier to determine. 3. The NPV method is better because it shows the size of the project so you can see how much value a project has not just a percentage. You could have a higher percentage but a much lower value and you would still go for the lower percentage. g. 1. It is like the IRR except that the assumption is that you can invest the cash flows at the WACC instead of at the IRR itself. The MIRR for Franchises L and S are: a. MIRR for Franchise L – 16% b. MIRR for Franchise S –

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