You have just graduated from the MBA program of alarge university, and one of your favorite courses was“Today’s Entrepreneurs.” In fact, you enjoyed it somuch you have decided you want to “be your ownboss.” While you were in the master’s program, yourgrandfather died and left you $1 million to do withas you please. You are not an inventor, and you donot have a trade skill that you can market; however,you have decided that you would like to purchase atleast one established franchise in the fast-foods area,maybe two (if profitable). The problem is that youhave never been one to stay with any project for toolong, 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 twochoices: (1) Franchise L, Lisa’s Soups, Salads, &Stuff, and (2) Franchise S, Sam’s Wonderful FriedChicken. The net cash flows shown below includethe price you would receive for selling the franchisein Year 3 and the forecast of how each franchise willdo over the 3-year period. Franchise L’s cash flowswill start off slowly but will increase rather quicklyas people become more health conscious, whileFranchise S’s cash flows will start off high but willtrail off as other chicken competitors enter the mar-ketplace and as people become more health con-scious and avoid fried foods. Franchise L servesbreakfast and lunch, while Franchise S serves onlydinner, so it is possible for you to invest in bothfranchises. You see these franchises as perfect com-plements to one another: You could attract both thelunch and dinner crowds and the health consciousand not so health conscious crowds without thefranchises directly competing against one another.

Here are the net cash flows (in thousands ofdollars):

EXPECTED NET CASH FLOW

Year Franchise L Franchise S

0 ($100) ($100)1 10 702 60 503 80 20

Depreciation, salvage values, net working capitalrequirements, and tax effects are all included in thesecash flows.

You also have made subjective risk assessmentsof each franchise, and concluded that both fran-chises have risk characteristics that require a returnof 10 percent. You must now determine whether oneor both of the franchises should be accepted.

a. What is capital budgeting?b. What is the difference between independent and

mutually exclusive projects?c. (1) What is the payback period? Find the pay-

backs for Franchises L and S.(2) What is the rationale for the payback method?

According to the payback criterion, whichfranchise or franchises should be accepted ifthe firm’s maximum acceptable payback is2 years, and if Franchises L and S are inde-pendent? If they are mutually exclusive?

(3) What is the difference between the regularand discounted payback periods?

(4) What is the main disadvantage of discountedpayback? Is the payback method of any realusefulness in capital budgeting decisions?

d. (1) Define the term net present value (NPV).What is each franchise’s NPV?

(2) What is the rationale behind the NPVmethod? According to NPV, which franchiseor franchises should be accepted if they areindependent? Mutually exclusive?

(3) Would the NPVs change if the cost of capi-tal changed?

e. (1) Define the term internal rate of return(IRR). What is each franchise’s IRR?

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

(3) What is the logic behind the IRR method?According to IRR, which franchises shouldbe accepted if they are independent? Mutu-ally exclusive?

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

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

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(2) Look at your NPV profile graph withoutreferring to the actual NPVs and IRRs.Which franchise or franchises should beaccepted if they are independent? Mutuallyexclusive? Explain. Are your answers correctat any cost of capital less than 23.6 percent?

g. (1) What is the underlying cause of rankingconflicts between NPV and IRR?

(2) What is the “reinvestment rate assumption,”and how does it affect the NPV versus IRRconflict?

(3) Which method is the best? Why?h. (1) Define the term modified IRR (MIRR). Find

the MIRRs for Franchises L and S.(2) What are the MIRR’s advantages and disad-

vantages vis-à-vis the regular IRR? What arethe MIRR’s advantages and disadvantagesvis-à-vis the NPV?

i. As a separate project (Project P), you are consider-ing sponsoring a pavilion at the upcoming World’sFair. The pavilion would cost $800,000, and it isexpected to result in $5 million of incremental cashinflows during its 1 year of operation. However, itwould then take another year, and $5 million ofcosts, to demolish the site and return it to its origi-nal condition. Thus, Project P’s expected net cashflows look like this (in millions of dollars):

Year Net Cash Flows

0 ($0.8)1 5.02 (5.0)

The project is estimated to be of average risk, soits cost of capital is 10 percent.(1) What are normal and nonnormal cash flows?(2) What is Project P’s NPV? What is its IRR?

Its MIRR?(3) Draw Project P’s NPV profile. Does Project

P have normal or nonnormal cash flows?Should this project be accepted?

j. What does the profitability index (PI) measure?What are the PI’s of Franchises S and L?

k. In an unrelated analysis, you have the opportu-nity to choose between the following two mutu-ally exclusive projects:

EXPECTED NET CASH FLOW

Year Project S Project L

0 ($100,000) ($100,000)1 60,000 33,5002 60,000 33,5003 — 33,5004 — 33,500

The projects provide a necessary service, sowhichever one is selected is expected to berepeated into the foreseeable future. Both proj-ects have a 10 percent cost of capital.(1) What is each project’s initial NPV without

replication?(2) Now apply the replacement chain approach

to determine the projects’ extended NPVs.Which project should be chosen?

(3) Now assume that the cost to replicate Proj-ect S in 2 years will increase to $105,000because of inflationary pressures. Howshould the analysis be handled now, andwhich project should be chosen?

l. You are also considering another project thathas a physical life of 3 years; that is, the machin-ery will be totally worn out after 3 years. How-ever, if the project were terminated prior to theend of 3 years, the machinery would have a pos-itive salvage value. Here are the project’s esti-mated cash flows:

Initial Investment End-of-Yearand Operating Net Salvage

Year Cash Flows Value

0 ($5,000) $5,0001 2,100 3,1002 2,000 2,0003 1,750 0

Using the 10 percent cost of capital, what is theproject’s NPV if it is operated for the full3 years? Would the NPV change if the companyplanned to terminate the project at the end ofYear 2? At the end of Year 1? What is the proj-ect’s optimal (economic) life?

m. After examining all the potential projects, youdiscover that there are many more projects thisyear with positive NPVs than in a normal year.What two problems might this extra large capi-tal budget cause?

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Chapter 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk • 477

Shrieves Casting Company is considering adding anew line to its product mix, and the capital budget-ing analysis is being conducted by Sidney Johnson, arecently graduated MBA. The production line wouldbe set up in unused space in Shrieves’s main plant.The machinery’s invoice price would be approxi-mately $200,000, another $10,000 in shippingcharges would be required, and it would cost anadditional $30,000 to install the equipment. Themachinery has an economic life of 4 years, andShrieves has obtained a special tax ruling that placesthe equipment in the MACRS 3-year class. Themachinery is expected to have a salvage value of$25,000 after 4 years of use.

The new line would generate incremental salesof 1,250 units per year for 4 years at an incrementalcost of $100 per unit in the first year, excludingdepreciation. Each unit can be sold for $200 in thefirst year. The sales price and cost are both expectedto increase by 3 percent per year due to inflation.Further, to handle the new line, the firm’s net operat-ing working capital would have to increase by anamount equal to 12 percent of sales revenues. Thefirm’s tax rate is 40 percent, and its overall weightedaverage cost of capital is 10 percent.a. Define “incremental cash flow.”

(1) Should you subtract interest expense or divi-dends when calculating project cash flow?

(2) Suppose the firm had spent $100,000 lastyear to rehabilitate the production line site.Should this be included in the analysis?Explain.

(3) Now assume that the plant space could beleased out to another firm at $25,000 peryear. Should this be included in the analysis?If so, how?

(4) Finally, assume that the new product line isexpected to decrease sales of the firm’s otherlines by $50,000 per year. Should this beconsidered in the analysis? If so, how?

b. Disregard the assumptions in part a. What isShrieves’s depreciable basis? What are theannual depreciation expenses?

c. Calculate the annual sales revenues and costs(other than depreciation). Why is it important toinclude inflation when estimating cash flows?

d. Construct annual incremental operating cashflow statements.

e. Estimate the required net operating workingcapital for each year and the cash flow due toinvestments in net operating working capital.

f. Calculate the after-tax salvage cash flow.g. Calculate the net cash flows for each year. Based

on these cash flows, what are the project’s NPV,IRR, MIRR, and payback? Do these indicatorssuggest that the project should be undertaken?

h. What does the term “risk” mean in the contextof capital budgeting; to what extent can risk bequantified; and when risk is quantified, is thequantification based primarily on statisticalanalysis of historical data or on subjective, judg-mental estimates?

i. (1) What are the three types of risk that are rel-evant in capital budgeting?

(2) How is each of these risk types measured,and how do they relate to one another?

(3) How is each type of risk used in the capitalbudgeting process?

j. (1) What is sensitivity analysis?(2) Perform a sensitivity analysis on the unit

sales, salvage value, and cost of capital forthe project. Assume that each of these vari-ables can vary from its base-case, orexpected, value by �10, 20, and 30 percent.Include a sensitivity diagram, and discussthe results.

(3) What is the primary weakness of sensitivityanalysis? What is its primary usefulness?

k. Assume that Sidney Johnson is confident of herestimates of all the variables that affect the proj-ect’s cash flows except unit sales and sales price.If product acceptance is poor, unit sales would beonly 900 units a year and the unit price wouldonly be $160; a strong consumer response wouldproduce sales of 1,600 units and a unit price of$240. Johnson believes that there is a 25 percentchance of poor acceptance, a 25 percent chanceof excellent acceptance, and a 50 percent chanceof average acceptance (the base case).(1) What is scenario analysis?(2) What is the worst-case NPV? The best-case

NPV?

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(3) Use the worst-, most likely, and best-caseNPVs and probabilities of occurrence to findthe project’s expected NPV, standard devia-tion, and coefficient of variation.

l. Are there problems with scenario analysis?Define simulation analysis, and discuss its prin-cipal advantages and disadvantages.

m. (1) Assume that Shrieves’s average project has acoefficient of variation in the range of 0.2 to0.4. Would the new line be classified as high

risk, average risk, or low risk? What type ofrisk is being measured here?

(2) Shrieves typically adds or subtracts 3 percentagepoints to the overall cost of capital to adjust forrisk. Should the new line be accepted?

(3) Are there any subjective risk factors thatshould be considered before the final deci-sion is made?

n. What is a real option? What are some types ofreal options?

478 • Part 3 Project Valuation

A paper on the effect of inflation on capital budget-ing is

Mehta, Dileep R., Michael D. Curley, and Hung-GayFung, “Inflation, Cost of Capital, and CapitalBudgeting Procedures,” Financial Management,Winter 1984, pp. 48–54.

The following articles pertain to other topics in thischapter:

Kroll, Yoram, “On the Differences between AccrualAccounting Figures and Cash Flows: The Case ofWorking Capital,” Financial Management, Spring1985, pp. 75–82.

Mukherjee, Tarun K., “Reducing the Uncertainty-Induced Bias in Capital Budgeting Decisions—AHurdle Rate Approach,” Journal of BusinessFinance & Accounting, September 1991, pp.747–753.

The literature on risk analysis in capital budgeting isvast; here is a small but useful selection of addi-tional references that bear directly on the topicscovered in this chapter:

Butler, J. S., and Barry Schachter, “The InvestmentDecision: Estimation Risk and Risk Adjusted Discount Rates,” Financial Management, Winter1989, pp. 13–22.

Weaver, Samuel C., Peter J. Clemmens III, Jack A.Gunn, and Bruce D. Danneburg, “Divisional Hur-dle Rates and the Cost of Capital,” FinancialManagement, Spring 1989, pp. 18–25.

The following cases from Textchoice, ThomsonLearning’s online library, cover many of the con-cepts discussed in this chapter and are available athttp://www.textchoice2.com.

Klein-Brigham Series:

Case 12, “Indian River Citrus Company (A),”Case 12A, “Cranfield, Inc. (A),” and Case 14,“Robert Montoya, Inc.,” focus on cash flow esti-mation. Case 13, “Indian River Citrus (B),” Case13A, “Cranfield, Inc. (B),” Case 13B, “TastyFoods (B),” Case 13C, “Heavenly Foods,” andCase 15, “Robert Montoya, Inc. (B),” illustrateproject risk analysis. Case 58, “Universal Corpo-ration,” is a comprehensive case that illustratesChapters 13 and 14, as do Cases 47 and 48, “TheWestern Company (A and B).”

Brigham-Buzzard Series:

Case 7, “Powerline Network Corporation (Riskand Real Options in Capital Budgeting).”

SELECTED ADDITIONAL REFERENCES AND CASES

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