Question

4. Timco airlines is a large airplane maker. It recently built the T123. It can carry 500 passengers on two levels. Initial project investments were $13B. Assume that the initial investment was paid on Dec 31, 2010. Assume that Timco will produce 60 aircraft per year for five years. Each aircraft will be sold for $230M and total operating costs are 75% of revenues. Assume that revenues and costs occur at year-end with the first revenues (and costs) occurring on Dec 31, 2011. What is the NPV of the project if Timco’s cost of capital is 11%? Calculate the NPV as of Dec 31, 2010. Ignore taxes and assume that there are no terminal year cash flows. Show your work, as appropriate and clearly state your answer (5 points) 5. What is the payback period for the Timco investment outlined in #4? What does the payback period calculation mean? In other words, interpret your answer. 6. What is the Profitability Index as of Dec 31, 2010 for the Timco investment outlined in #4? 7. Timco’s CFO wants you to provide a recommendation – but based on only one of the three sets of analysis above (either NPV, Payback or Profitability Index). Which method do you choose? Why?

Answer 1

		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=Cost of capital=11%	0.11
		N=Year of Cash Flow
			($ Million)
	N	YEAR	0	1	2	3	4	5
	A	Initial Investment	($13,000)
	B=230*60	Sales revenue		$13,800	$13,800	$13,800	$13,800	$13,800
	C=0.75B	Operating Costs		-$10,350	-$10,350	-$10,350	-$10,350	-$10,350
	D=A+B+C	Net Cash Flow	($13,000)	$3,450	$3,450	$3,450	$3,450	$3,450	SUM
		Cumulative Cash Flow	($13,000)	($9,550)	($6,100)	($2,650)	$800	$4,250
	PV=D/(1.11^N)	Present Value (PV) of Net Cash Flow:	($13,000)	$3,108	$2,800	$2,523	$2,273	$2,047	($249)
	NPV=Sumof PV	NPV as of Dec31, 2010	($249)
		Pay Back Period=Period at which Cumulative cash flow=NIL
		Pay Back Period=(3+(2650/3450)=	$3.77	Years
		It means the initial investment is recovered in 3.77 years
		If we ignore time value of money, the project starts making profit after payback period
		Profitability Index =(NPV+Initial cost)/Initial Cost
		Profitability Index =(-249+13000)/13000=	0.98
		NPV method should be used
		It considers time value of money .It is in sync with the corporate objective of maximizing shareholders wealth
		A positive NPV indicates amount of shareholders wealth created