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Business Finance Question Paper

Business Finance

Course:Bachelor Of Commerce In Finance (Finance)

Exam Year:2011

BUSINESS FINANCE
End of semester exam 2011
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 investor, 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 frames is3 years. After 3 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, and Stuff, and (2) franchise S, Sam’s wonderful fried chicken. The net cash flows shown below include the price you would receive for the franchise in Year 3 and forecast of how each franchise will do over the 3-year period. Franchise L’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 without the franchises directly competing against one with another.
Here are the 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 requirement, and fax effects are all included in these cash flows.
You also have made subjective risk assessments of each franchise, and concluded that both franchises have risk characteristics that require return of 10 percent. You must now determine whether one or both of the franchises should be accepted.
• What is capital budgeting?(2 marks)
• What is the difference between independent and mutually exclusive projects?(2 marks)
• I) what is the payback period? Find the paybacks for Franchises L and S.(4 marks)
II) What is the rationale for the payback method?(2 marks)
According to the payback criterion, which franchise or franchises should be accepted if the firm’s maximum acceptable payback is 2 years, and if Franchises L and S are independent? If they are mutually exclusive. (2 marks)
III) What is the difference between the regular and discounted payback periods?(4 marks)
IV) What is the main disadvantage of discounted payback? Is the payback method of any real usefulness in capital budgeting decisions?(4 marks)

? (1) Define the term net present value (NPV). What is each franchise’s NPV?(4 marks)
(2) What is the rationale behind the NPV method?(2 marks)
According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
(3) Would the NPVs change if the cost of capital changed?(4 marks)

? (1) Define the term internal rate of return (IRR). What is each franchise’s IRR?(4 marks)
(2) How is IRR on a project related to the YTM on a bond?(2 marks)
(3) What is the logic behind the IRR? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?(4 marks)
(4) Would the franchises’ IRRs change if the cost of capital changed?(5 marks)

? (1) Draw NPV profiles for Franchises L and S. at what discount rate do the profiles cross?(5 marks)
(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or franchises should be accepted if they are independent? Mutually exclusive? Explain. Are your answers correct at any cost of capital less than 23.6 percent?(6 marks)

? (1) What is the underlying cause of ranking conflicts between NPVand IRR?(4 marks)
(2) What is the “reinvestment rate assumption,” and how does it affect the NPV and IRR?(6 marks)
(3) Which method is the best? Why?(4 marks)

? (1) Define the term modified IRR (MIRR). Find the MIRRS for Franchises L and S.(6 marks)
(2)What are the MIRRs advantages and disadvantages vis-à-vis the regular IRR? What are the MIRR’s advantages and disadvantage vis-à-vis the NPV?(4 marks)

? As a separate project (project P), you are considering sponsoring sponsoring a pavilion at the upcoming Worlds Fair. The pavilion would cost $800,000 and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash flows look like this (in millions of dollars)
YEAR NET CASH FLOWS
0 ($0.8)
1 5.0
2 (5.0)

The project is estimated to be of average risk, so its cost of capital is 10 percent.
1. What are normal and non-normal cash flows?(2 marks)
2. What is Project P’s NPV? What is its IRR? It’s MIRR?(4 marks)
3. Draw Project P’s profile. Does Project P have normal or non-normal cash flows? Should this project be accepted?(4 marks)

? In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects;

EXPECTED NET CHASH FLOW
YEAR PROJECT S PROJECT L
0 ($100,000) ($100,000)
1 60,000 33,500
2 60,000 33,500
3 - 33,500
4 - 33,500

The projects provide a necessary service, so whichever one is selected to be repeated into the foreseeable future. Both projects have a 10 percent cost of capital.
1. What is each project’s initial NPV without replication?(2 marks)
2. Now apply the replacement chain approach to determine the projects’ extended NPVs. Which project should be chosen?(4 marks)

? You are also considering another project which has a physical life of 3years; that is, the machinery will be totally worn out after 3 years. However, if the project were terminated prior to the end of 3 years, the machinery would have appositive salvage value. here are the project’s estimated cash flows;

Year Initial investment and operating cash flows End-of-year net salvage value
0 ($5,000) ($5,000)
1 2,100 3,100
2 2,000 2,000
3 1,750 0

Using the 10 percent cost of capital, what is the project’s NPV if it is operated for the full 3 Years? Would the NPV change if the company planned to terminate the project at the end of Year 2? At the end of year 1? What is the project’s optimal (economic) life?(2 marks)

1. After examining all the potential projects, you discover that there are many more projects this year with positive NPVs than in a normal year. What two problems might this extra large capital budget cause?(2 marks)
(Total Marks 100)

Business Finance Question Paper

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