Mini Case You have just graduated with a business degree from a large university, and one of your favourite 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 died and left you $1 million 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-food 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 3 years. After 3 years you will 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 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 these franchises as perfect complements to each other: 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 each other. Discount Rate = Required rate of return= 10% Expected Net Cash Flow Year Franchise L Franchise S 0 -100 -100 1 10 65 2 60 50 3 80 20 a) Calculate NPV= $18.78 IRR= 18.126% MIRR 16.50% Decision if Independent Decision if Mutually Projects Exclusive projects NPV > O so accept both ProjL because NPV > ProjS Explain the difference between MIRR and IRR and when you would use MIRR. b) Find the payback and discount payback periods for these projects Franchise L 0 1 2 3 Franchise S 0 1 2 3 -100 10 60 80 -100 65 50 20 Cumulative CF -100 -90 -30 50 Payback Period 2.38 years Cumulative CF Payback Period years Franchise L 0 1 2 3 Franchise S 0 1 2 3 -100 10 60 80 -100 65 50 20 PV of CF -100 $9.09 $49.59 $60.11 PV of CF -100 Cumulative CF -100 ($90.91) ($41.32) $18.78 Cumulative CF Discounted Payback Period 2.69 years years Discounted Payback Period What is the usefulness of the payback and discounted payback methods? Are either of them useful for project decision making? c) Find the Crossover Point Year Step i) Calculate the difference 0 between Franchise L & S Cashflows 1 -55 2 10 3 60 Step ii) Find the Crossover rate for Crossover Rate = these Cashflow Differences Explain what a crossover rate is. Year 0 d) In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects. Discount rate 10% Project (100,000) Project X (100,000) 1 60,000 33,000 2 60,000 33,000 3 4 33,000 33,000 Mutually Exclusive Decision Calculate NPV= EAA= e) Adifferent project being considered has the following Cash Flows Discount rate 10% Year Project X 0 (800,000) 1 5,000,000 2 (5,000,000) Decision NPV= IRR= Explain why the decisions are contradictory, and explain which technique you should trust. Shrek Casting Company is considering adding a new line to its product mix. The production line would be set up in unused space in Shrek's' main plant. The machinery's invoice price would be approximately $200,000; another $10,000 in shipping charges would be required; and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of 4 years, and would be a class 8 with a 20% CCA rate. The machinery is expected to have a salvage value of $20,000 after 4 years of use. The new line would generate incremental sales of 1,300 units per year for four years at an incremental cost of $125 per unit in the first year, excluding depreciation. Each unit can be sold for $225 in the first year. The sales price and cost are expected to increase by 3% per year due to inflation. Further, to handle the new line, the firm's net operating working capital would have to increase by an amount of $37,000. The firm's tax rate is 31%, and its overall weighted average cost of capital is 10 percent. I. Utilize the Components Cash Flows Approach to analyze Shrieves new product project Your Name(s) INPUT DATA r = T = 10% 31% d = CCA rate = Machine Cost = 200,000 Shipping Cost = Installation cost = Change in NOWC = # Units = Price = Costs = Inflation = Salvage Value = Economic life = A. Initial Outlay (in 1000s) New Machine Cost 200.00 Plus: Setup & Training Capital Cost 200.00 Change in NOWC Initial Investment CF 200.00 years Key Output: NPV = $ (200.00) B. Operating Cash Flows (in 1000s) Intial Outlay # Units Yrs 1 2 3 Price Costs NCF-BT Tax NCF-AT PV of Operating CF's $0.000 C. Ending Cash Flows Salvage Value NOWC Recovery NCFs PV of Salv + NOWC $0.00 D. NPV of CCA Tax Shield C = Cost S= Salv Value d= CCA rate= T = 200.00 r= cost of capital = n= PV of CCATS= #DIV/O! PVCCATS = NPV = Investment Outlay + PV Project CF + PV CCATS + PV Ending CF Investment Outlay $ PV of Operating CF PV CCATS (200.00) PV Ending CF NPV of project $ (200.00) PROJECT Decision: ACCEPT / REJECT CdT (1+0.5r 1+r (Sd) 1 1+r)n, II. Sensitivity Analysis Sensitivity analysis measures the effect of changes in a particular variable, say revenues, on a project's NPV. To perform a sensitivity analysis, all variables are fixed at their expected values except one. This one variable is then changed, often by specified percentages, and the resulting effect on NPV is noted. An Excel "Data Table" is used below to find NPV for unit sales, salvage value, and cost of capital for the project, with the deviations from base case. This produces the sensitivity analysis for WACC as shown below. NPV NPV NPV Dev from base case -20% WACC 8% #DIV/0! Units Sold #DIV/0! #DIV/0! -20% 1000 38.23 -20% Salvage #DIV/O! 20 #DIV/0! -10% 9% #DIV/0! -10% 1125 58.33 -10% 22.5 #DIV/O! 0% 10% #DIV/O! 0% 1250 86.61 0% 25 #DIV/O! 10% 11% #DIV/0! 10% 1375 114.9 10% 27.5 #DIV/0! 20% 12% #DIV/0! 20% 1500 143.18 20% 30 #DIV/O! NPV Values for Deviations from Base Case Sensitivity Analysis 1 0.9 Dev from base 0.8 case WACC Units Sold Salvage 0.7 -20% Copy Copy Copy 0.6 0.5 -10% Cells Cells Cells 0.4 0% C72 to F72 to 172 to 0.3 10% C76 F76 20% Here Here 176 Here 0.2 0.1 0 -20% -10% 0% 10% 20% Deviation from Base-Case Value (%) What does this graph show you? WACC III. Scenario Analysis Scenario analysis extends risk analysis in two ways: (1) It allows us to change more than one variable at a time, hence to see the combined effects of changes in several variables on NPV, and on NPV (2) It allows us to bring in the probabilities to see the combined effects of changes in several variables Units Sold -Salvage Scenario Probability Unit Sales Unit Price NPV (1000's) Squared Deviation times probability Best Case 25% 1600 Base Case 50% 1300 Worst Case 25% 900 $240.00 $200.00 $160.00 $ $ 293.58 (200.00) $25,629.06 $15,032.71 $176.97 These NPV values are copied from the appropriate worksheet Mean = Expected NPV = Standard Deviation = Coefficient of Variation = Std Dev / Expected NPV = ($27) $202 Can be compare this with other projects scenario analysis results If typical range of CoV for company projects is 0.7 to 1.0, then would this project be considered more or less riskly? IV. NPV Break-even Variable Price Machine Cost # units Makes NPV = 0 Use Goal Seek (in Data - Forecast - What if Analysis) 10% Key Output: 31% NPV= $ 102.80 d = CCA rate= 20% Machine Cost- Goal Seek ? 200,000 Shipping Cost 10,000 Set cell: SE$17 1 Installation cost = 30,000 Change in NOWC = 37,000 To value: #Units= 1,300 By changing cell: 50$23 + Price- 225 Costs= 125 OK Cancel Inflation- 3% Salvage Value= 20,000 Economic life- 4.00 years