Question

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 $1 million to do with as you please. You are not an inventor 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 frame is three years. After three 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, & Stuff and (2) Franchise S, Sam’s Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the three-year period. Franchise L’s cash flows will start off slowly but will increase rather quickly as people become more health conscious, while Franchise S’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 another.

Here are the net cash flows (in thousands of dollars):

                                                                                 Expected Net Cash Flows

                                            Year                 Franchise L                    Franchise S

                                                               0                             ($100)                             ($100)

                                               1                                  10                                   70

                                               2                                  60                                   50

                                               3                                  80                                   20

Depreciation, salvage values, net working capital requirements, and tax 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 a return of 10%. You must now determine whether one or both of the franchises should be accepted.

What is each franchise’s IRR?

How is the IRR on a project related to the YTM on a bond? For example, suppose the initial cost of a project is $100 and it has cash flows of $40 at Years 1, 2, and 3. What is its IRR?

What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?

Would the franchises’ IRRs change if the cost of capital changed?

Answer 1

Internal Rate of Return (IRR) for each Franchise's

Franchise L

Year	Cash Flow ($) (A)	Present Value Factor @ 10% (B)	Discounted Cash Flow @ 10% ($) ( A X B)	Present Value Factor @ 20% (C)	Discounted Cash Flow @ 20% ($) ( A X C)
1	10	0.9091	9.09	0.833	8.33
2	60	0.8265	49.59	0.694	41.64
3	80	0.7513	60.10	0.579	46.32
	Total		118.78		96.29

Internal Rate of Return (IRR) for Franchise L = 10% + 18.78 / 22.49 X 10%

= 10% + 8.35%

IRR = 18.35%

Franchise S

Year	Cash Flow ($) (A)	Present Value Factor @ 10% (B)	Discounted Cash Flow @ 10% ($) ( A X B)	Present Value Factor @ 25% (C)	Discounted Cash Flow @ 25% ($) ( A X C)
1	70	0.9091	63.64	0.800	56
2	50	0.8265	41.33	0.640	32
3	20	0.7513	15.03	0.512	10.24
	Total		120		98.24

Internal Rate of Return (IRR) for Franchise S = 10% + 20 / 21.76 X 15%

= 10% + 9.91%

IRR = 19.91%

From the above calculation Franchise S IRR is greater than Franchise L so Franchise S should be accepted.

IRR is a percentage discount rate used in capital investment appraisals which brings the cost of a project and its future cash inflows into equality. It is the rate of return which equates the present value of anticipated net cash inflows with the initial outlay. IRR will not change if the cost of capital will changed.