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# FM11 31 - present value basis This \$18.79 excess PV belongs...

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Mini Case: 11 - 31 c. 2. What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive? Answer: The rationale behind the NPV method is straightforward: if a project has NPV = \$0, then the project generates exactly enough cash flows (1) to recover the cost of the investment and (2) to enable investors to earn their required rates of return (the opportunity cost of capital). If NPV = \$0, then in a financial (but not an accounting) sense, the project breaks even. If the NPV is positive, then more than enough cash flow is generated, and conversely if NPV is negative. Consider franchise L's cash inflows, which total \$150. They are sufficient (1) to return the \$100 initial investment, (2) to provide investors with their 10 percent aggregate opportunity cost of capital, and (3) to still have \$18.79 left over on a
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Unformatted text preview: present value basis. This \$18.79 excess PV belongs to the shareholders--the debtholders' claims are fixed, so the shareholders' wealth will be increased by \$18.79 if franchise L is accepted. Similarly, Axis's shareholders gain \$19.98 in value if franchise S is accepted. If franchises L and S are independent , then both should be accepted, because they both add to shareholders' wealth, hence to the stock price. If the franchises are mutually exclusive , then franchise S should be chosen over L, because s adds more to the value of the firm. c. 3. Would the NPVs change if the cost of capital changed? Answer: The NPV of a project is dependent on the cost of capital used. Thus, if the cost of capital changed, the NPV of each project would change. NPV declines as r increases, and NPV rises as r falls....
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