FIN 34220 Lecture Notes - Lecture 1: Gross Domestic Product
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You have just completed your undergraduate degree, 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 program, your grandfather died and left you $300,000 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):
Expected | ||
net cash flows | ||
Year | Franchise S | Franchise L |
0 | ($100) | ($100) |
1 | 70 | 10 |
2 | 50 | 60 |
3 | 20 | 80 |
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 10 percent. You must now determine whether one or both of the projects should be accepted.
In order to do so please answer the following questions fully. Make sure to show a time line, the formula to be used, the steps taken to solve the problem (calculator or excel) and the final numerical answer when appropriate.
Questions:
Define the term net present value (NPV).
What is each franchise's NPV? Make sure to show the formula, steps and final answer.
Based on your answer which franchise would you select? Why?
Would your answer be different if the projects are independent or mutually exclusive? Why or why not?
Would the NPVs change, and therefore your answer, if the cost of capital changed? Why or why not?
Internal Rate of Return (IRR) â you may use a financial calculator or excel. (Worth 8 points)
What is the logic/idea behind the IRR method?
Calculate the IRR for each project. Make sure to show the formula, calculator or excel steps and final answer.
According to IRR, which franchise should be accepted if they are independent? Mutually exclusive? Why?
Would the franchises' IRRs change if the cost of capital changed? Why or why not?
Define the term modified IRR (MIRR).
Find the MIRRs for Franchise L and S. Make sure to show the formula, steps and final answer.
What are the MIRR's advantages and disadvantages vis-a-vis the regular IRR? What are the MIRR's advantages and disadvantages vis-a-vis the NPV?
What is the rationale for the payback method?
Calculate the payback period for each franchise. Make sure to show the formula, steps and final answer.
Calculate the discounted payback period for each franchise. Make sure to show the formula, steps and final answer.
According to the payback criterion, which franchise or franchises should be accepted if the firm's maximum acceptable payback is 2 years, and if Franchise L and S are independent? If they are mutually exclusive? Why?
What is the difference between the regular and discounted payback periods? Make sure to mention the advantage and disadvantage of each.
Based on the results obtained and everything that you have described above, which franchise would you ultimately choose if the projects are mutually exclusive? Explain in detail your decision and why you chose the model you did to make your final decision.
ch 14
#7
Suppose you have been hired as a financial consultant to Defense Electronics, Inc. (DEI), a large, publicly traded firm that is the market share leader in radar detection systems (RDSs). The company is looking at setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a five-year project. The company bought some land three years ago for $4.2 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. The land was appraised last week for $5.0 million. In five years, the aftertax value of the land will be $5.4 million, but the company expects to keep the land for a future project. The company wants to build its new manufacturing plant on this land; the plant and equipment will cost $31.76 million to build. The following market data on DEIâs securities are current:
Debt: | 227,000 7.4 percent coupon bonds outstanding, 25 years to maturity, selling for 109 percent of par; the bonds have a $1,000 par value each and make semiannual payments. |
Common stock: | 8,500,000 shares outstanding, selling for $70.70 per share; the beta is 1.2. |
Preferred stock: | 447,000 shares of 6 percent preferred stock outstanding, selling for $80.70 per share. |
Market: | 8 percent expected market risk premium; 6 percent risk-free rate. |
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9 percent on new common stock issues, 7 percent on new preferred stock issues, and 5 percent on new debt issues. Wharton has included all direct and indirect issuance costs (along with its profit) in setting these spreads. Wharton has recommended to DEI that it raise the funds needed to build the plant by issuing new shares of common stock. DEIâs tax rate is 38 percent. The project requires $1,225,000 in initial net working capital investment to get operational. Assume Wharton raises all equity for new projects externally and that the NWC does not require floatation costs.. |
a. | Calculate the projectâs initial time 0 cash flow, taking into account all side effects. (Negative amount should be indicated by a minus sign. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answer to the nearest whole dollar amount.) |
Cash flow | $ |
b. | The new RDS project is somewhat riskier than a typical project for DEI, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of 3 percent to account for this increased riskiness. Calculate the appropriate discount rate to use when evaluating DEIâs project. (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) |
Discount rate | % |
c. | The manufacturing plant has an eight-year tax life, and DEI uses straight-line depreciation. At the end of the project (that is, the end of year 5), the plant and equipment can be scrapped for $4.2 million. What is the aftertax salvage value of this plant and equipment? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.) |
Aftertax salvage value | $ |
d. | The company will incur $6,500,000 in annual fixed costs. The plan is to manufacture 15,500 RDSs per year and sell them at $10,650 per machine; the variable production costs are $9,250 per RDS. What is the annual operating cash flow (OCF) from this project? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.) |
Operating cash flow | $ |
e. | DEIâs comptroller is primarily interested in the impact of DEIâs investments on the bottom line of reported accounting statements. What will you tell her is the accounting break-even quantity of RDSs sold for this project? (Do not round intermediate calculations and round your final answer to nearest whole number.) |
Break-even quantity | units |
f. | Finally, DEIâs president wants you to throw all your calculations, assumptions, and everything else into the report for the chief financial officer; all he wants to know is what the RDS projectâs internal rate of return (IRR) and net present value (NPV) are. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your final answers to 2 decimal places. (e.g., 32.16)) |
IRR | % |
NPV | $ |