Capital Budgeting Case Study

a. Capital budgeting is how a firm decides whether it should invest in a project. To determine if a project should be invested in, firms use methods such as net present value and internal rate of return to analyze the projected cash flows. Firms should choose projects that increase its value.

b. An independent project is a project that is not affected by the acceptance or rejection of another project. Mutually exclusive projects are projects that are affected by the acceptance of another project. Both projects cannot be chosen if they are mutually exclusive, but both projects can be rejected.

c. 1. Net present value determines the profitability of a project by finding the present value of the project’s cash flows. The net present value for Franchise L is $18.78 and $19.98 for Franchise S.

The equivalent annual annuity for Project S is $2,380.95 and $1,952.92 for Project L. IF these projects are mutually exclusive, Project S should be accepted because its equivalent annual annuity is higher than the Project L’s.

3. When the replacement chain approach is used Project S should be chosen because it has a higher NPV.

4. Under this scenario, Project L should be chosen because its NPV is higher than Project L. The $105,000 is included in the year 2 cash flow.

l. If operated the full 3 years, the NPV of this project is -$123.22. The NPV for a 2-year termination is $214.88 and -$272.73 for a termination at the end of year 1. The project should be used for 2 years then terminated at the end of two years, which is its economic life.

m. A problem that could occur is a lack of capital. A lack of capital means less projects can be pursued unless more capital is raised. If more capital is raised the cost of capital will also increase which will lead to the acceptability of some projects changing. The second problem that could occur is capital rationing. The capital budget may be limited due to not wanting to relinquish equity or a lack of skilled