Question
I tried to solve this problem. Is this correct? James Polk Hospital has currently unused space in its lobby. In three years, the space will
I tried to solve this problem. Is this correct?
James Polk Hospital has currently unused space in its lobby. In three years, the space will be required for a planned expansion, but the hospital is considering uses of the space until then. The hospital has decided that it wants to purchase at least one and maybe two fast food franchises, to take advantage of the high volume of patients and visitors that walk through the lobby all day long. The hospital plans to purchase the franchise(s), operate them for three years, and then close them down. The hospital has narrowed its selection down to two choices:
Franchise L: Lisa's Soups, Salads, and Stuff
Franchise S: Sam's Wonderful Fried Chicken
The net cash flows shown below include the costs of closing down the franchises in Year 3 and the forecast of how each franchise will do over the three-year period. Franchise L serves breakfast and lunch, while Franchise S serves only dinner, so it is possible for the hospital to invest in both franchises. The hospital believes these franchises are perfect complements to one another: The hospital could attract both the breakfast/lunch and dinner crowds and both the health-conscious and not-so-health-conscious crowds without the franchises directly competing against one another. The corporate cost of capital is 10 percent.
Net Cash Flows | ||
Year | Franchise S | Franchise L |
0 | -$100,000 | -$100,000 |
1 | $70,000 | $10,000 |
2 | $50,000 | $60,000 |
3 | $20,000 | $80,000 |
a. Calculate each franchise's payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR).
b. Which project or projects should be accepted if they are independent? Which project should be accepted if they are mutually exclusive? Please explain.
c. Suppose the hospital could sell off the equipment for each franchise at the end of any year. Use NPV to determine the optimal economic life of each franchise when the salvage values are as follows:
Salvage Values | ||
Year | Franchise S | Franchise L |
0 | $100,000 | $100,000 |
1 | $60,000 | $70,000 |
2 | $20,000 | $30,000 |
3 | $0 | $0 |
Here are my answers:
Part a: | |||||||||||
Project S | Project L | ||||||||||
Payback Period | 1.6 | 2.38 | |||||||||
Discounted Payback | 1.88 | 2.69 | |||||||||
NPV | $19,985 | $18,783 | |||||||||
IRR | 23.6% | 18.1% | |||||||||
MIRR | 16.9% | 16.5% | |||||||||
Part b: | |||||||||||
If the projects are independpent, the hospital should except both. If the projects are mutually exculsive, the hospital should chose Project S based on the higher NPV. | |||||||||||
Explanation:
The NPV method of capital budgeting dictates that all independent projects that have positive NPV should be accepted. The rationale is that all such projects add wealth, which should be the goal of the financial management function. If two mutually exclusive projects were being evaluated, the one with the higher NPV should be chosen. In addition, the shorter the payback period is the better investment generally speaking. Projects should be accepted if their IRR is greater than the cost of capital. When mutually exclusive projects are being evaluated, the one with the higher IRR should be chosen.
Part c:
The optimal economic life of Franchise S is in year one while Franchise L is year three. Franchise S NPV is positive earlier than Franchise L because the cash flows from Franchise S are received faster than Franchise L
PROJECT S
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| NPV | 98,948 |
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