Exam 2 Finance 470 Key

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Exam 2 Finance 470

1. When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.

The EAC approach is appropriate when comparing mutually exclusive projects with different lives that will be replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared; in effect, each project is assumed to exist over an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid implies that the project cash flows remain the same forever, thus ignoring the possible effects of, among other things: (1) inflation, (2) changing economic conditions, (3) the increasing unreliability of cash flow estimates that occur far into the future, and (4) the possible effects of future technology improvement that could alter the project cash flows.

2. The Army has requested a bid for multiple use digitizing devices (MUDDs). They will require the winner of the bid to deliver 4 units each year for the next 3 years. You have estimated that labor and materials costs will be $10,000 per unit. Production space can be leased for $12,000 per year. The project will require $50,000 in fixed assets with expected salvage of $10,000 at the end of the project (depreciate straight-line to salvage value) and an initial $10,000 increase in NWC. Your marginal tax rate = 34% and the required return = 15%. What is your minimum bid?

NPV = 0 = -60,000 + OCF(PVIFA15%,3) + 20,000(PVIF15%,3)

NPV = 0 = -60,000 + (NI + Dep)(2.2832) + 20,000(0.6575)

NPV = 0 = -60,000 + [(S – VC – FC - Dep)(1 – T) + Dep](2.2832) + 13,150.32

46,849.68 = [(4P – 4(10,000) – 12,000 – 13,333.33)(1 - .34) + 13,333.33](2.2832)

20,519.31 = (4P – 65,333.33)(0.66) + 13,333.33

7,185.98 = (4P – 65,333.33)(0.66)

10,887.85 = 4P – 65,333.33

76,221.18 = 4P

19,055.21 = P

3. As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, the cash break-even point, or the financial break-even point? Why?

From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder (your) wealth.

4. In an effort to capture the large jet market, Airbus invested $13 billion developing its A380, which is capable of carrying 800 passengers. The plane has a list price of $280 million. In discussing the plane, Airbus stated that the company would break even when 249 A380s were sold.

a. Assuming the break-even sales figure given is the cash flow break-even, what is the cash flow per plane?

The cash flow per plane is the initial cost divided by the breakeven number of planes, or: Cash flow per plane = $13,000,000,000 / 249
Cash flow per plane = $52,208,835

b. Airbus promised its shareholders a 20 percent rate of return on the investment. If sales of the plane continue in perpetuity, how many planes must the company sell per year to deliver on this promise?

In this case the cash flows are a perpetuity. Since we know the cash flow per plane, we need to determine the annual cash flow necessary to deliver a 20 percent return. Using the perpetuity equation, we find: PV = C /R

$13,000,000,000 = C / .20
C = $2,600,000,000

This is the total cash flow, so the number of planes that must be sold is the total cash flow divided by the cash flow per plane, or: Number of planes = $2,600,000,000 / $52,208,835

Number of planes = 49.80 or about 50 planes per year

c. Suppose instead that the sales of the A380 last for only 10 years. How many planes must Airbus sell per year to deliver the same rate of return?...
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