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Exam 9: Capital Budgeting Techniques

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Question 31

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What is the payback period for the Boeing 787 Dreamliner project? The Boeing 787-8 can carry 230 passengers up to 8,200 nautical miles at a cruising speed of mach 0.85. The Dreamliner is more comfortable for passengers because of higher cabin humidity. Boeing completed construction of its final assembly plant in Everett Washington in December 2007 at a total cost of $7B. Boeing has secured sales of 865 aircraft over the period 2008-2012 for total proceeds of $138.4B ($160M per aircraft) . The cost of building each plane is $140M. Assume that sales (and costs) occur in December of each year. Assume that sales are spread evenly across the five years from 2008-2012. The project cash flows are shown in the table, below. What is the payback period for the project? Ignore taxes. $\begin{array} { | c | c | c | c | c | c | } \hline \text { Year } & \begin{array} { c } \text { Capital } \\\text { Investment }\end{array} & \text { Annual Sales } & \begin{array} { c } \text { Annual } \\\text { Revenues }\end{array} & \text { Annual Costs } & \text { Cash Flows } \\\hline 2007 & - \$ 7,000 \mathrm { M } & & & & - \$ 7,000 \\\hline 2008 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \\\hline 2009 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \\\hline 2010 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \\\hline 2011 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \\\hline 2012 & & 173 & \$ 27,680 & \$ 24,220 & \$ 3,460 \\\hline\end{array}$

A) 2 months
B) 2.02 years
C) 3.4 years
D) 7 years
E) 24 years

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Question 32

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Michigan Mattress Company is considering the purchase of land and the construction of a new plant. The land, which would be bought immediately (at t = 0) , has a cost of $100,000 and the building, which would be erected at the end of the first year (t = 1) , would cost $500,000. It is estimated that the firm's after-tax cash flow will increase by $100,000 starting at the end of the second year, and that this incremental flow would increase at a 10 percent rate annually over the next 10 years. What is the approximate payback period?

A) 2 years
B) 4 years
C) 6 years
D) 8 years
E) 10 years

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Question 33

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What is the NPV of the F-22 Raptor project? The Lockheed Martin/Boeing F-22 Raptor is a stealth fighter aircraft. It was designed primarily as an air superiority fighter, but it is also capable of ground attack and other roles. Lockheed Martin Aeronautics is the prime contractor and is responsible for the majority of the airframe, weapon systems and final assembly. Lockheed Martin invested over $10B on design and manufacturing for the aircraft. Assume that those investments were paid for on Jan 1, 2003. Each aircraft will be sold for $350M and the variable cost of building each airplane is $300M. Assume that 70 aircraft will be sold each year for 5 years. Assume that revenues and costs occur at year-end. (So 2003 revenues and costs are incurred on Dec 31, 2003. See the table of cash flows, below.) What is the NPV of the project if Lockheed-Martin's cost of capital is 10%? (Assume that there are no taxes.) $\begin{array} { | c | c | c | c | } \hline \text { Date } & \text { Investments } & \text { Revenues } & \text { Costs } \\\hline \text { Jan. } 1,2003 & \$ 10 \mathrm {~B} & & \\\hline \text { Dec. } 31,2003 & & \$ 24.5 \mathrm {~B} & \$ 21 \mathrm {~B} \\\hline \text { Dec. } 31,2004 & & \$ 24.5 \mathrm {~B} & \$ 21 \mathrm {~B} \\\hline \text { Dec. } 31,2005 & & \$ 24.5 \mathrm {~B} & \$ 21 \mathrm {~B} \\\hline \text { Dec. } 31,2006 & & \$ 24.5 \mathrm {~B} & \$ 21 \mathrm {~B} \\\hline \text { Dec. } 31,2007 & & \$ 24.5 \mathrm {~B} & \$ 21 \mathrm {~B} \\\hline\end{array}$

The Barby Division at Mattel Toys is considering the acquisition of a laser tattoo applicator that will be able to add custom-designed tattoos to the Barby doll. The machine costs $300M. The addition of tattoos to the iconic toy is expected to increase demand and raise free cash flow by $90 million over the next five years (at the end of each year) . The machine has no anticipated resale value in five years. What is the project's IRR?

Which of the following statements is false?

The project cash flows and Profitability Indexes for Projects A and B are provided in the table below. If the two projects are not mutually exclusive and there are no capital constraints, which project(s) should you select? $\begin{array} { | c | c | c | } \hline & \text { Project A } & \text { Project B } \\\hline \text { Year 0 } & - \$ 1,900 & - \$ 2,000 \\\hline \text { Year 1 } & \$ 2,500 & \$ 1,550 \\\hline \text { Year 2 } & \$ 1,500 & \$ 1,900 \\\hline \text { PI } & 1.7411 & 1.3923 \\\hline\end{array}$

If the calculated NPV is negative, then which of the following must be true? The discount rate used is:

A firm is evaluating two independent projects utilizing the internal rate of return technique. Project X has an initial investment of $80,000 and cash inflows at the end of each of the next five years of $25,000. Project Z has a initial investment of $120,000 and cash inflows at the end of each of the next four years of $40,000. The firm should:

What is the payback period for the Airbus A380 project? The Airbus A380 is the largest civilian aircraft ever built. It can carry 555 passengers on two decks. Initial project investments were $13B. Assume that the initial investment was paid on Dec 31, 2008. Assume that Airbus 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, 2009. Ignore taxes and assume that there are no terminal year cash flows. Select the earliest year such that the initial investments are completely paid off.

What is the Profitability Index of the Airbus A380 project? The Airbus A380 is the largest civilian aircraft ever built. It can carry 555 passengers on two decks. Initial project investments were $13B. Assume that the initial investment was paid on Dec 31, 2008. Assume that Airbus 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, 2009. Assume that Airbus' cost of capital is 11%. Calculate the Profitability Index as of Dec 31, 2008. Assume that there are no terminal year cash flows.

Your company is planning to open a new gold mine which will cost $3 million to build, with the expenditure occurring at the end of the year three years from today. The mine will bring year-end after-tax cash inflows of $2 million at the end of the two succeeding years, and then it will cost $.5 million to close down the mine at the end of the 3rd year of operation. What is the project's IRR?

Costner Inc. would like to introduce its new haircutting machine, the "terminator." The machine will cost $15,000 today. As a result of purchasing the machine, Costner expects to give 5,000 more haircuts for $8 each. In the first year, Costner will give 2,000 more haircuts, and in the second year Costner will give 3,000 more haircuts. What is the net present value (NPV) associated with purchasing the terminator if Costner's cost of capital is 9%? Round answer to the nearest whole dollar amount.

All of the following are considered to be disadvantages of using the payback method except the fact that it:

You are considering the purchase of an investment that would pay you $5,000 per year for Years 1-5, $3,000 per year for Years 6-8, and $2,000 per year for Years 9 and 10. If you require a 14% rate of return, and the cash flows occur at the end of each year, then how much should you be willing to pay for this investment?

The capital budgeting director of Sparrow Corporation is evaluating a project which costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14% and its tax rate is 40%, what is the projected IRR?

What is the internal rate of return for a project that requires a current cash outlay of $15,187 and is expected to generate cash inflows of $5,000 at the end of each of the next four years?

In 1967, Lockheed planned to build a wide-bodied passenger aircraft called the L-1011 Tri Star airbus. The pre-production phase of the Tri Star project was planned to end in 1971 and total $1B. Lockheed planned to sell 35 aircraft per year for six years between 1972 and 1977 with an operating profit of $2M per aircraft. This sales forecast was aggressive as it represented a market share of 45% of the world market for wide-bodied aircraft (which was forecast to be about 80 aircraft per year) . By 1971 the company was in financial distress and had to seek a government bailout. At the end of 1967, Lockheed had 11.3 million shares outstanding which traded at $70 per share. If the market had known the NPV of the L-1011 project at that time, then what would the stock price have been?

According to the internal rate of return method, a firm should accept a project if the ________.

According to the net present value technique, a project is considered acceptable if:

An advantage of the net present value (NPV) method is that it: