Rainbow Products

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Advanced Finance
1. Homework

Investment Analysis

1. QuestionRainbow Products

Savings - $5000/year
Machine costs $35.000
Expected to last for 15 years
Cost of capital 12%

A. payback?, NPV?, IRR?

Payback: The amount of time required for a firm to recover its initial investment. by dividing the initial investment by the annual cash inflow.

In our case $35.000/$5000= 7years

NPV: Investment- the PV of its cash inflows discounted at a rate( the firm’s cost of capital)

NPV= -$35.000- $34.054= -$946 so NPV less than $0, the project rejected IRR: discount rate, with IRR the NPV=0

IRR= 11,49%
IRR less than the cost of capital (12%), we reject the project.

B. payback?, NPV?, IRR?

Payback:
In this case $35.000/$4500= 7,77years=8years

NPV: Investment- the PV of its cash inflows discounted at a rate( the firm’s cost of capital) In perpetuity means: constant stream of cash flows with no end – PV= C/r

NPV= -$35.000+$37500= $2500 so NPV greater than $0, the project accepted IRR: discount rate, with IRR the NPV=0

IRR= 12,86%
IRRgreater than the cost of capital (12%), we accept the project.

C. payback?, NPV?, IRR?

Payback: mixed of cash inflows, we accumulated until the investment is recovered In this case in 7th year is $31.593 it’s not enough so in 8th year will be recovered

NPV: Investment- the PV of an initial end-of-year perpetuity payout of $C (growing at g%) per period, with a discount rate of k%: = PV= C/(k-g)

NPV= -$35.000+ $50000= $15000 so NPV greater than $0, the project accepted IRR: discount rate, with IRR the NPV=0

IRR= 15,43%
IRRgreater than the cost of capital (12%), we accept the project.

2. Question„Ball park”

In case of IRR calculation we recommend the project D, so renting a larger stand. Because a project with a higher IRR value than other options would still provide a much better chance of strong growth. Near NPV results we can recommend the project C, so building a new stand. Because of Cproject has the highest NPV. Differences between the IRR and NPV rankings: NPV assumes reinvestment of intermediate cash inflows at the more conservative cost of capital, while the IRR assumes reinvestment at the project’s IRR. On theoretical basis NPV is preferred over IRR because NPV assumes the more conservative reinvestment rate. On the other hand the IRR is more commonly used because it is consistent with the general preference of businesspeople for rates of return.

5. Question Lockheed Tri Star

* preproduction costs between 1967-1971: $900 million
* production 1971-1976: 210 planes
* plane delivered in year after production, (25%(140m/560m) of revenue received as deposit * revenues- $16million/unit
* production costs $14million/unit (or $12,5million/unit if produces 300units or more)

Planes/year: 210/6=35
production costs (1971-1976): 35*$14million= $490million/year revenues(1972-1977) : 35*$16m= $560milliondeposits 0,25*560=$140millionRevenue on delivery:$560m-$140m= $420million

The true value of the Tri Star program at the planned production level of 210 units was much lower than expected. Based on NPV calculation, the Tri star program is economically unfavorable for Lockheed.

Break-even rules

According to accounting break-even rules, Lockheed reports where each unit makes an overall profit of $3.5M, resulting in a total profit $962.5M, which is above the $960 pre-production figures. However, 300 units would yield more profits, in net present value terms, the cash inflows are still not strong enough with only 300 units. Thus, Lockheed doesn’t break-even.To find the actual sales volume that allows the Tri Star program to reach true economic break-even, we set the NPV to 0. Also, taking into account learning curve effects as the production size increases the NPV calculations show us that it is possible to break-even at approximately 400 units. Strongly support rejecting the project...
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