Define the internal rate of return

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Reference no: EM133433885

You have just graduated from the MBA program of a large university, and one of your favorite courses was "Today's Entrepreneurs." 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, 000,000 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). 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 L: Lisa's Soups, Salads, & Stuff and (2) Franchise S: Sam's Fabulous Fried Chicken. 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 L's cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise S's cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health conscious and avoid fried foods. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: you could attract both the lunch and dinner crowds and the health conscious and not so health conscious crowds without the franchises' directly competing against one another. Here are the net cash flows (in thousands of dollars):

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 9 percent. You must now determine whether one or both of the projects should be accepted.

Answer:

1. What is the NPV of each project?

2. Which project should be accepted if:(i) they are independent? (ii) mutually exclusive?

3. Define the Internal Rate of Return. What is the IRR for each project?

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

5. According to IRR, which franchise should be accepted (i) if they are independent? (ii) mutually exclusive?

6. (i) Would the franchises' IRRs change if the cost of capital changed? (ii) What does the IRR method assume as the re-investment rate of future cash flows?

7. What is the crossover rate for the two projects NPV?

Reference no: EM133433885

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