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 million to do with as you please. You are not an inventor, and you do not have to trade skill that you can market; however you have decided that you would like to purchase at least one established franchise in the fast food area, maybe two (if profitable). The problem is that you have never been one to say with any project for too long, so you figure that your time frame is 3 years. After 3 years you will go on to something else.
You have narrowed your selection down to choices (1) Franchise L, Lisa's Soups, Salads, & stuff and, (2) Franchise S, Sam's Fabulous Fried Chicken. The net cash flows below include the price you would receive for selling the franchise in 3 years and the forecast of how each franchise will do over the 3 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 the 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):
Expected Net Cash Flow
Year Franchise L Franchise S
0 ($100) ($100)
1 10 70
2 60 50
3 80 20
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
You are also have made subjective risk assessments of each franchise and concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the franchises should be accepted.
What is each franchise's IRR?
What are MIRRs for franchises L and S.?
Draw NPV profiles for franchises L and S. At what discount rate do the profiles cross?
Look at your NPV profile graph without referring to the actual NPVs and IRRs which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6%?
The solution explains how to determine which franchise to buy using IRR, MIRR and NPV