1. Case analysis:

You have just graduated with a business degree from 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 studying, your grandfather passed away 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 five years. After five 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 5 and the forecast of how each franchise will do over the five-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 with the franchises directly competing against one another.

Here are the projects' free cash flows (in thousands of dollars):

Amortization, salvage values, net working capital requirements, and tax effects are all included in these free 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 10 percent. You must now determine whether one or both of the projects should be accepted.

a) What is capital budgeting? What are the steps in a typical capital budgeting process?

b) What is project free cash flow? What are the factors included in determining a project's FCF's? Be thorough about your discussion.

c) Define the term net present value (NPV). What is each franchise's NPV? According to the NPV rationale, which project should be accepted if they are independent? Mutually exclusive?

d) Define the term internal rate of return (IRR). What is each franchise's IRR? According to the IRR rationale, which project should be accepted if they are independent? Mutually exclusive?

e) Define the payback period (PBP) and discounted payback period (DPBP). What are the payback period and discounted payback period for each franchise? Which franchise should be accepted if the firm's maximum acceptable payback is 2 years?

f) Define the modified internal rate of return (MIRR). What is the MIRR for each franchise? Assume that the reinvestment rate is equal to 12%.

g) Draw NPV profiles for both the franchises. Fully discuss both NPV profiles. You need to use excel to construct the NPV profiles.

h) Discuss the advantages and disadvantages of the following ranking methods: NPV, IRR, PBP and MIRR.

i) What are real options? Discuss various types of real options.

j) Why is risk analysis so important? Discuss the three different risk analysis techniques. Perform a sensitivity analysis based on project's net cash flows and required return. Excel should be used to perform this analysis.