Case Study: Capital Budgeting

Case Study: Capital Budgeting

Introduction

This case study is mainly focus on using capital budgeting criteria to solve the investment dilemma at Meal-Wise Holdings between two restaurants in Auckland. The two restaurants are (1) Soup and Salad Wonder (SSW) and (2) Crispy Chicken Station (CCS). Table 1 indicates the cash flow projections of each restaurant in three years’ time, including the acquisition expense, estimated operating cash flows and resale prices. Both two projects have equal risk and 10% rate of return. Cost of purchasing, depreciation, salvage value, net working capital requirement and tax effects are included in the cash flow projections either. Follow the assumption that customers’ healthy eating knowledge will increase over time, the expectation of SSW’s cash flows will be lower at the start and higher in the future, and CCS’s cash flows will have an opposite trend. Following analyses are focus on the choice of acquirement between the two restaurants by using capital budgeting criteria of Ehrhardt and Brigham(2011), based on the assumption that these two restaurants are mutually exclusive.

Table 1. Cash flow projections.

Franchise SSW Year 0 1 2 3

Purchase price -$500,000

Net operating cash flow $100,000 $150,000 $200,000

Resale price $500,000

Total cash flow -$500,000 $100,000 $150,000 $700,000

Franchise CCS Year 0 1 2 3

Purchase price -$500,000

Net operating cash flow $250,000 $150,000 $100,000

Resale price $400,000

Total cash flow -$500,000 $250,000 $150,000 $500,000

The NPV Profiles

In order to draw the net present value (NPV) profiles for SSW and CCS, the calculations in Table 2 have firstly been taken with different values of cost of capital (e.g., 0%, 10%, 20%, 30%, 40%). These data are used to draw Figure 1. The data of crossover point with its relevant NPVs and the NPVs of internal rate of returns (IRRSSW and IRRCCS) are also calculated.

Table 2. The data set of NPV profiles.

Cost of Capital NPVSSW NPVCCS

0% $450,000 $400,000

10% $240,796 $226,897

20% $92,593 $101,852

30% -$15,703 $8,648

40% -$96,939 -$62,682

Crossover = IRR△= 15.47% $153,766 $153,766

IRRSSW