Obamacare

a. What is capital budgeting?

Capital budgeting is a process of analyzing projects and deciding which ones to accept and include in capital budget.

The first step in project analysis is to estimate the project`s expected cash flows. The second step is to calculate the next evaluation measures:

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Modified Internal Rate of Return (MIRR)

4. Profitability Index (PI)

5. Regular Payback

6. Discounted Payback

b. What is the difference between independent and mutually exclusive projects?

Mutually exclusive projects are two or more different ways of accomplishing the same result. And if one project is accepted the other must be rejected. If two projects are mutually exclusive we accept the one that has higher positive NPV.

Independent projects cash flow is not affected by other projects. They should be excepted if the NPV is positive and thus brings value to the firm.

c. (1) Define the term net present value (NPV). What is each franchise`s NPV?

The NPV is defined as the present value of project`s expected cash flows discounted at the risk-adjusted rate.

Franchise L NPV = -100 + 10/1.1 + 60/(1.1)^2 + 80/(1.1)^3 = 18.782870 thousands of dollars

Franchise S NPV = -100 + 70/1.1 + 50/(1.1)^2 + 20/(1.1)^3 = 19.984974 thousands of dollars

(2) What is the rational behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent?

Mutually exclusive?

The NPV measures how much wealth the project contributes to shareholders. In our case both franchises have a positive NPV what means that they both add value to our wealth.

Since these franchises are perfect complements to one other, they are independent projects. Both franchises we want to buy because both of them have positive NPV`s.

If they would be mutually exclusive, then we would buy just Franchise S, as it has the highest NPV.

(3) Would the NPV`s change if the cost of capital changed?

If the cost of capital would be 20% instead of 10%, then NPV`s for both franchises would be changed:

Franchise