CORPORATE FINANCE - MODULE 6 MINICASE Essay Example | Topics and Well Written Essays - 2750 words

CORPORATE FINANCE - MODULE 6 MINICASE - Essay Example This means that it generates enough cash to recover the cost of investment and the return that the investors want. If both franchise L and S are independent, then both of them should be accepted as both of them have a positive NPV. On the other hand, if they are mutually exclusive, then franchise S should be selected, as it gives a higher NPV value. (3) Would the NPV's change if the cost of capital changed (Ehrhardt & Brigham, 2006) The NPV inversely depends on the cost of capital. Therefore, if NPV increases then the cost of capital decreases; and, if the NPV decreases then the cost of capital increases. d. (1) Define the term internal rate of return (IRR). What is each franchise's IRR (Ehrhardt & Brigham, 2006) The IRR is the discount rate at which NPV is equal to zero. Expressed as an equation, we have: IRR: = $0 = NPV. 0 18.1% 1 2 3 | | | | -100.00 10 60 80 8.47 43.02 48.57 $ 0.06 $0 Franchise L's IRR is 18.1%. 0 23.6% 1 2 3 | | | | -100.00 70 50 20 56.63 32.73 10.59 $ (0.05) $0 Franchise S's IRR is 23.6% (2) How is the IRR on a project related to the YTM on a bond (Ehrhardt & Brigham, 2006) As the YTM is the promised rate of return on a bond, the IRR is the expected rate of return on a project. (3) What is the logic behind the IRR method According... Independent projects are those whose cash flows are not affected by the acceptance of another project. On the other hand, mutually exclusive projects are those whose cash flows are affected by the acceptance of another project. The rationale behind the NPV method is that if NPV=$0, then the project breakevens in a financial sense (but not in the accounting sense). This means that it generates enough cash to recover the cost of investment and the return that the investors want. If both franchise L and S are independent, then both of them should be accepted as both of them have a positive NPV. On the other hand, if they are mutually exclusive, then franchise S should be selected, as it gives a higher NPV value. IRR measures a project's profitability in the rate of return sense: if a project's IRR equals its cost of capital, then its cash flows are just sufficient to provide investors with their required rates of return. An IRR greater than r implies an economic profit, which accrues to the firm's shareholders, while an IRR less than r indicates an economic loss, or a project that will not earn enough to cover its cost of capital. No, the IRR wouldn't be affected by a change in the cost of capital. It should be noted, however, that the acceptability of the IRR may change if the cost of capital changes. For example, franchise L would be rejected if the cost of capital increases beyond 18.1%. (2)