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By purchasing paint mixing machine to reduce labor cost, Rainbow products can

generate cash flow of $5000 per year. The machine costs 35000 and expected to
last for 15 years. Rainbow products determine the cost of capital is 12%.
[A] On the slide I have stream of cash flow from the date of purchase t=0 till 15
years later. This is an annuity, in which the paint mixing machine pays out a fixed
cash flow of 5000 annually for 15 years.
With the investment cost of 35000 and discount rate of 12%, using excel function,
we get NPV= -945.68, IRR =11.49%, pay back period is 7 years.
Should not purchase the project

[B] with $500 additional expenditure, Rainbow products can get a service that can
keep the machine in new condition forever. With the service contract, the machine
would produce cash flows of $4500 per year perpetuity.
Should purchase the project with service contract.

[C]Instead of service contract, Rainbow engineers come up with a plan that can
preserve and enhance the machine capability by reinvesting 20% of the annual cost
saving back into new machine parts to increase cost savings at 4% per year
perpetuity.
The slide show cost saving increasing 4% per year, and 20% cost saving will be
reinvested. Subtracting the cost of reinvestment, we will get a stream of perpetual
cash flow also grow at 4%.
This is an example of growing perpetuity,
Three projects are mutually exclusive, rainbow should go with the third one cause
highest NPV and IRR.

2) Concession stand with three years left on the contract with the park. Long lines
limits sales and profits.
We have four different proposals and with incremental cash flows.

The first proposal is to renovate by adding another window.


The second is to update the equipment at the existing windows.
These two renovation projects are not mutually exclusive; you could take both projects. The third
and fourth proposals involve abandoning the existing stand.
The third proposal is to build a new stand.
The fourth proposal is to rent a larger stand in the ball park. This option would involve $1000 in
up-front investment for new signs and equipment installation.
15% discount rate is appropriate for this type of investment.

Project 4 has higher IRR but lower NPV compared to project 3.


For IRR ranking, Project 4 is the highest;
but for NPV ranking, Project 3 is the highest.
The NPV rule is better because project with positive NPV will of course has higher IRR
than its discount rate.
Moreover, NPV evaluate the projects the same way that investors do; therefore, it is
consistent with the objective of shareholder wealth maximization.
IRR rule works well but it also has many weaknesses that would lead to confusion.
The conflict in IRR and NPV rankings of mutually exclusive projects arises because of
differences in the timing of their cash flows.
NPV takes into account the size differences in initial investment while IRR does not.
The reason for conflicting rankings is that IRR implicitly assumes that intermediate cash
flows occurring during the life of the project can be reinvested at a rate equal to IRR,
whereas NPV implicitly assumes a reinvestment rate equal to the projects cost of capital.
Even though project 3 requires much larger up-front investment, it brings more value.

The decision to pursue Tri Star is not reasonable.


At the wildly optimistic assumption of 10% annual growth in air travel

Total World market


share
Share
Expected demand

775
35%
271.25

40%
310

323
35%
113.05

40%
129.2

At a more realistic 5% growth rate

Free world market


share
Share
Expected demand

Lockheed had overestimated the demand because its break even point was 480 unit at
production cost of $12.5 million per unit.

Number of share
outstanding
Jan-67
Jan-71

11,300,000
63
10
$598,900,00
0.00)

Total decrease in shareholders value: $598,900 million.

Lockheed should go seek for a $250 million federal guarantee to secure bank credit required for
completion the Tri Star program.