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RainMan Inc. is in the business of producing rain upon request. The firm must decide between...

  1. RainMan Inc. is in the business of producing rain upon request. The firm must decide between two investment projects: a new airplane for seeding rain clouds or a new weather control machine built by Dr. Nutzbaum. The discount rate for the new airplane is 9%, while the discount rate for the weather machine is 39% (it happens to have higher market risk). If selected, the airplane or the weather machine would be repetitively replaced at the end of its useful life. The cash flows for one cycle for each project are as follows:

Year

Airplane

Weather Machine

0

–900

–900

1

500

550

2

600

600

3

685

  2. Which investment should the company select and why? There is no inflation.

a.

Airplane, because it has a higher equivalent annual cash flow.

b.

Weather machine, because it has a higher NPV.

c.

Airplane, because it has a higher NPV.

d.

Weather machine, because it has a higher equivalent annual cash flow.

Solutions

Expert Solution

Airplane
Discount rate 9.000%
Year 0 1 2
Cash flow stream -900 500 600
Discounting factor 1.000 1.090 1.188
Discounted cash flows project -900.000 458.716 505.008
NPV = Sum of discounted cash flows
NPV Airplane = 63.72
Where
Discounting factor = (1 + discount rate)^(Corresponding period in years)
Discounted Cashflow= Cash flow stream/discounting factor
Equvalent annuity(EAA)= 23.09
Required rate =   9.000%
Year 0 1 2
Cash flow stream 23.09 23.09 23.09
Discounting factor 1.000 1.090 1.188
Discounted cash flows project 23.094 21.188 19.438
Sum of discounted future cashflows = 63.72
Discounting factor = (1 + discount rate)^(Corresponding period in years)
Discounted Cashflow= Cash flow stream/discounting factor
Weather machine
Discount rate 39.000%
Year 0 1 2 3
Cash flow stream -900.000 550.000 600.000 685.000
Discounting factor 1.000 1.390 1.932 2.686
Discounted cash flows project -900.000 395.683 310.543 255.062
NPV = Sum of discounted cash flows
NPV Weather machine = 61.29
Where
Discounting factor = (1 + discount rate)^(Corresponding period in years)
Discounted Cashflow= Cash flow stream/discounting factor


Equvalent annuity(EAA)= 23.49
Required rate =   39.000%
Year 0 1 2 3
Cash flow stream 23.49 23.49 23.49 23.49
Discounting factor 1.000 1.390 1.932 2.686
Discounted cash flows project 23.489 16.898 12.157 8.746
Sum of discounted future cashflows = 61.29
Discounting factor = (1 + discount rate)^(Corresponding period in years)
Discounted Cashflow= Cash flow stream/discounting factor

Weather machine as it has higher equivalent annuity amount

jeff jeffy answered 2 years ago
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