The Basics of Capital Budgeting: Evaluation Cash Flows

Topics: Net present value, Capital budgeting, Internal rate of return Pages: 10 (5627 words) Published: November 3, 2014

Write Up: Mini Case ofChapter 10: The Basics of Capital Budgeting: Evaluation Cash Flows Oct 2, 2014
Executive Summary:
We heritage $1 million from our grandfather, and we just received our master degree in MBA, and because we love to be our own boss and, we don not have the skills to trade on the market, we decided to purchase an established franchise in the fast-food area to make some investments. We chose two franchises: L, Lisa’s Soups, Salads, & Stuff which serves breakfast and lunch; and S, Sam’s Fabulous Fried Chicken that serves dinner. We think these two franchises are perfect complement to each other, also we estimate that both projects has the same risk characteristics, and for that we required 10% for our return, but we do not have the ability to stay on the project for more than 3 years, for that reason we estimate the free cash flows for both projects for the next three years. The main problem here that we have to evaluate and determine whether one or both of the franchises should be accepted. To solve this problem, we used 6 capital budgeting techniques: net present value (NPV), internal rate of return (IRR), modified IRR (MIRR), profitability index (PI), payback and discounted payback. Each approach provides a different piece of information, so it is better to look at all of them when evaluating projects. Each one of them has it’s own strengths and weaknesses, which may help us to understand each project return liquidity and risk. Financial Theory:

Six capital budgeting decision criteria are used in this case: NPV, IRR, MIRR, PI, payback and discounted payback. Three other issues in capital budgeting are also discussed in the case: (1) how to choose mutual exclusive projects with unequal lives; (2) the potential advantage of terminating a project before the end of its physical life; (3) how to optimal capital budgeting. NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder wealth. IRR and MIRR measure how profitable the project will be in the future. PI also measures the profitability but as regard to the amount of investment. Payback and discounted payback measure the liquidity and risk of a project. When two mutually exclusive projects have unequal lives, applying replacement chain approach or equivalent annual annuity approach to determine which project to accept. A project’s true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life. The cost of capital might increase as the size of the capital budget increases. So if cost of capital increases the discounting rate will increase and will cause the NPV will decrease, also will effect the decision been made. In conclusion, different techniques provide different types of useful information; therefore most sophisticated firms will use all of the measures when making capital budgeting decisions. Mini Case Questions

What is capital budgeting?
Capital budgeting is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones that managers must make. This process is very important to the success or failure of the firm as the asset fixed investment decisions chart a company’s course for the future. What is the difference between independent and mutually exclusive projects? Independent projects are projects that are unrelated to each other and allow for each project to be evaluated on its own profitability. For example, if projects L and S are independent, and both are has positive NPV, and then the firm could accept both projects. Mutually exclusive projects means that only one project from a list of projects can be accepted and that the projects are compete with each other. For example if projects L, S and P were mutually exclusive, the firm could accept either project L, S or P, but not all. A capital budgeting decision between two different delivery trucks with different costs...
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