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RainMan Inc is in the business of producing rain upon request
RainMan Inc is in the business of producing rain upon request. They 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). Which investment should the company select and why? (Assume a 0% inflation rate.)
Year Airplane Weather Machine
0 -900 -900
1 500 550
2 600 600
3 685
Expert Solution
| 1] | NPV of New Airplane = -900+500/1.09+600/1.09^2 = | $ 63.72 |
| 2] | NPV of Weather Machine = -900+550/1.39+600/1.39^2+685/1.39^3 = | $ 61.29 |
| 3] | Using NPV as the criteria, New Airplane is to be | |
| selected as it has higher NPV. | ||
| 4] | But, as the two options have different lives [assuming | |
| that the two projects are repeatable, then the Equivalent | ||
| Annual NPV [Converting the above NPV into annuity | ||
| for the lives of the projects] should be calculated. | ||
| Equivalent Annual NPV: | ||
| For New Airplane = 63.72*0.09*1.09^2/(1.09^2-1) = | $ 36.22 | |
| For Weather Machine = 61.29*0.39*1.39^3/(1.39^3-1) = | $ 38.08 | |
| Using EANPV, the Weather Machine with higher EANPV is | ||
| to be selected, as it will give higher equated annual NPV. | ||
| Note: The decision using EANPV should be made only if, | ||
| the two projects are repeatable. |
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