Mini case

Name: Yi Ru 1077406

Class: FINC501-M01

Assignment of mini case

October 27, 2015

A. What is capital budgeting?

Capital budgeting is the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget.

B. What is the difference between independent and mutually exclusive projects? Independent projects means that I have so much money that I can invest a lot of projects at the same time. So if the profits are higher than my expectation, I will invest it. Mutually exclusive projects means that my money is limited so I must choose the best one of the investments. If I choose the one of them, I cannot choose others at all.

C. (1) Define the term NPV. What is each franchise’s NPV?

The rationale of the NPV method is defined as the present value of a project’s expected cash flows discounted at the appropriate risk-adjusted rate.

The Franchise L’s NPV is $18.7829.

The Franchise S’s NPV is $19.9850.

(2) What is the rationale behind the NPV method? Acoording to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?

The NPV method help us know the present value of future cash flows are equal to investment which is made today. If the NPV more than zero, it will be worthy investing. If they are independent, both of them should be invested because the NPVs of them are positive. If they are Mutually exclusive, the Franchises S should be invested duo to its higher NPV.

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

Yes, if the cost of capital goes up, the NPVs will go down.

D. (1) Define the term IRR. What is each franchise’s IRR?

IRR is the rate of return when NPV=0.

The Franchise L’s IRR is 18.1258%.

The Franchise S’s IRR is 23.5641%.

(2) How is the IRR on a project related to the YTM on a bond?

They are the same thing. If you invest in the bond, the YTM of the bond is the IRR.

(3) What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?

IRR measures a project’s profitability in the rate of return sense: if a project’s IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. If they are independent, both of them should be invested because the IRRs of them are both higher than 10%. If they are mutually exclusive, Franchise S should be invested due to its higher IRR.

(4) Would the franchises’ IRRs change if the cost of capital changed?

No, IRRs are independent of the cost of capital.

E. (1) Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?

The data of the curve shows below.

R NPVL NPVS

0.00% $50.00 $40.00

5.00% $31.48 $27.90

10.00% $17.08 $18.17

15.00% $5.80 $10.28

20.00% -$3.09 $3.86