Question

1. The Promoter Chairperson of a leading Jewellery chain in Kerala had recently procured a Corporate Jet. The purchase price of the Jet is $ 300 million and the pre-tax operational costs of the Jet is $ 50 million per annum. The management of the firm estimates that this asset will be under-utilized. The Jet can be used to fly the management also for important meetings in Mumbai and Delhi, which will reduce the current travel expenses of the management by $ 40 million. However, flying the management along with Chairperson would result in an additional pre-tax operational cost of $ 30 million per annum for the Jet. The management also estimates that this additional activity of flying the management team would force the Jet to be replaced in three years rather than four years, when used only by the Chairperson. Beyond its useful life, the Jet can be sold for $ 100 million, in both the scenarios. The use of corporate Jet is indispensable for the firm and will continue in the future. Assuming the Jet be depreciated using the straight line method to zero book value in both cases, the opportunity cost of capital to be 10%, the corporate tax rate to be 20%, which option should the firm choose?

Answer 1

Computation of Net present value of using jet only by chairperson:

Sl No	Year	0	1	2	3	4
i	Pre-tax operational cost of jet (given)		50,000,000	50,000,000	50,000,000	50,000,000
ii	Depreciation (300million/4years)		75,000,000	75,000,000	75,000,000	75,000,000
iii	EBIT (-i-ii)		(125,000,000)	(125,000,000)	(125,000,000)	(125,000,000)
iv	Tax savings @ 20% (iii*20%)		(25,000,000)	(25,000,000)	(25,000,000)	(25,000,000)
v	PAT (iii-iv)		(100,000,000)	(100,000,000)	(100,000,000)	(100,000,000)
vi	Add back: Depreciation (ii)		75,000,000	75,000,000	75,000,000	75,000,000
vii	Operating cash flow (v+vi)		(25,000,000)	(25,000,000)	(25,000,000)	(25,000,000)
viii	Purchase price (given)	(300,000,000)
ix	Sale value after tax (100million*(1-tax rate))					80,000,000
x	Net cash flow (vii+viii+ix)	(300,000,000)	(25,000,000)	(25,000,000)	(25,000,000)	55,000,000
xi	PVF @ 10% (1/[1.1^year])	1.0000	0.9091	0.8265	0.7514	0.6831
xii	Net present value of future cash flow (x*xi)	(300,000,000)	(22,727,500)	(20,662,500)	(18,785,000)	37,570,500

NPV of jet using only by chairperson = ΣNet present value of future cash flow = -324,604,500

Computation of Net present value of using jet by chairperson as well as management:

Sl No	Year	0	1	2	3
i	Savings in travel expenses (given)		40,000,000	40,000,000	40,000,000
ii	Pre-tax operational cost of jet (given)		50,000,000	50,000,000	50,000,000
iii	Additional Pre-tax operational cost of jet (given)		30,000,000	30,000,000	30,000,000
iv	Depreciation (100million/3years)		100,000,000	100,000,000	100,000,000
v	EBIT (i-ii-iii-iv)		(140,000,000)	(140,000,000)	(140,000,000)
vi	Tax savings @ 20% (v*20%)		(28,000,000)	(28,000,000)	(28,000,000)
vii	PAT (v-vi)		(112,000,000)	(112,000,000)	(112,000,000)
viii	Add back: Depreciation (iv)		100,000,000	100,000,000	100,000,000
ix	Operating cash flow (vii+viii)		(12,000,000)	(12,000,000)	(12,000,000)
x	Purchase price (given)	(300,000,000)
xi	Sale value after tax (100million*[1-tax rate])				80,000,000
xii	Net cash flow (ix+x+xi)	(300,000,000)	(12,000,000)	(12,000,000)	68,000,000
xiii	PVF @ 10% (1/[1.1^year])	1.0000	0.9091	0.8265	0.7514
xiv	Net present value of future cash flow (xii*xiii)	(300,000,000)	(10,909,200)	(9,918,000)	51,095,200

NPV of jet using by chairperson & management = ΣNet present value of future cash flow = -267,732,000

Since option 2 which is using jet by chairperson & management has low negative NPV, hence select option 2.

i.e. Allow management & chairperson to use the jet for official purpose.