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mini-case-ch10 - Chapter 10 The Basics of Capital Budgeting...

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Chapter 10 The Basics of Capital Budgeting Evaluating Cash Flows MINI CASE You have just graduated from the MBA program of a large university, 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 master’s 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 Wonderful 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 with the franchises directly competing against one another. Here are the projects' net cash flows (in thousands of dollars): Expected Net Cash Flow Year Franchise L Franchise S 0 ($100) ($100) 1 10 70 2 60 50 3 80 20 Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. Mini Case: 10 - 1
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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. a. What is capital budgeting? Answer: Capital budgeting is the process of analyzing additions to fixed assets . Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company's course for the future. Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions. These steps are involved: 1. Estimate the cash flows --interest and maturity value or dividends in the case of bonds and stocks, operating cash flows in the case of capital projects.
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