Introduction
To make commercially viable business decisions, it is necessary to consider various factors. By discussing the potential profits and expenses, it is possible to have an accurate view of a purchase or an investment. In the case study under discussion, franchises L and S are both prime candidates for investment, as their respective net present value (NPV), internal rate of return (IRR), Modified Internal Rate of Return (MIRR), and profitability index (PI) indicate their potential for profitability and growth.
Analysis
Capital budgeting is necessary to make better purchasing decisions. The practice is invaluable to small entrepreneurs who want to decide how to spend their capital (Kenton, 2022). Furthermore, the main difference between independent and mutually exclusive projects is that mutually exclusive projects compete for alternatives, while independent projects are not. According to the case study, franchises L and S are prime investment candidates. Their niches within the fast-food sphere are distinct. As a result, there is no direct competition between the two chains, which means that the two projects are independent.
To assess the benefits of acquiring the projects, it is necessary to determine their NPV. NPV is an economic tool for calculating a project’s or investment’s current value by considering all associated costs and their respective timeframes (“The importance of net present value for project managers,” 2022). For franchise L, the NPV is $18.78; for franchise S, it is $19.98. Franchise S is more profitable in the established timeframe of 3 years. Hence, the rationale behind assessing the NPV is to determine whether a given project can return its initial investment and be profitable. If the two franchises were mutually exclusive, it would be better to go forward with franchise S. However, as the two organizations are independent, it is possible to pick both instead. The potential NPV would change with the cost of capital. As the price of manufacture decreases, the NPV would further grow.
Next, the IRR is a measure of the return an investment will generate, expressed as a percentage of its initial cost. In the case study, 18.126% is the IRR for the first business, and 23.564% is for the second business. Moreover, the IRR of a project can be compared to the Yield to Maturity (YTM) of a bond. In the example scenario, the initial cost of a project is $100, and it has cash flows of $40 for three years. Using the Excel RATE Function, the IRR of this project is 16.67%. Evaluating a project by IRR is helpful when deciding which project is more sustainable and profitable, as the resulting percentage can be compared to the cost of capital (Corporate Finance Institute, 2022). Hence, S is more suitable for generating profit over time and should be accepted. Finally, the franchises’ IRRs would change if the cost of capital changed, as a higher cost of capital would indicate a higher rate of return for a project.
NPV profiles for L and S will show their respective NPV values at different discount rates. In the case study, the profiles will cross at a discount rate of 23.6% since this is the rate at which the NPV of Franchise S is $18.78. If the franchises are independent, both should be accepted since the NPV of both franchises is positive. If the franchises are mutually exclusive, the one with the higher NPV should be taken, which is Franchise S. This answer is correct at any cost of capital less than 23.6%. The reason for rating discrepancies between NPV and IRR is that NPV considers the time value of cash, but IRR does not.
The MIRR is an investment metric used to calculate the return of a project. It considers the reinvestment of cash flows at a different rate than the discounting rate (Moonfare, 2023). The MIRRs for Franchises L and S in the case study are 15.73% and 20.77%. Furthermore, the PI measures how attractive a potential investment will be. The PI for Franchise L is 1.1879; for Franchise S, it is 1.1999. Both values make these franchises acceptable for investing in, but Franchise S wins over by a narrow margin.
The final measure that can be applied to make an informed decision is determining the payback period. It is a method used to determine how long it will take to recover the cost of an investment. According to calculations, Franchise L will make a return on investment in 2.4 years, while the other franchise will become profitable in 1.6 years. The payback method’s rationale is to provide a quick and easy way to calculate the time it will take to recoup an initial investment. If the firm’s maximum permissible repayment is two years, it makes no difference whether the franchises are independent or mutually exclusive, based on the payback rule. Only S should be accepted, as it has a shorter payback period.
The difference between the regular and discounted payback periods is that the average payback period is calculated by dividing the total cost of the investment by the annual cash flows. The discounted payback period takes the cash’s time value into account by reducing cash flows to current value. The downside of discounted payback is that it does not account cash flows after the repayment period. Since it does not regard for the time cost of money, the payback technique is of limited utility in capital budgeting judgments.
Conclusion
As a result of consulting with the metrics, it was possible to determine that franchise S is a better financial investment over 3 years. In order to make more profit out of the initial investment, the investor must take advantage of the current success of the fast-food chain. It is also possible to fund both businesses, as they would be profitable, as well as are independent.
References
Corporate Finance Institute. (2022). Internal rate of return (IRR). Web.
Kenton, W. (2022). Capital budgeting: What it is and methods of analysis. Investopedia. Web.
Moonfare. (2023). Modified internal rate of return (MIRR). Web.
The importance of net present value for project managers. (2022). monday.com Blog. Web.