Question

You are contemplating the purchase of one-half interest in a corporate airplane to facilitate the expansion of your business into two new geographic areas. The acquisition would eliminate about $220,000 in estimated annual expenditures for commercial flights, mileage reimbursements, rental cars, and hotels for each of the next 10 years. The total purchase price for the half-share is $6 million, plus associated annual operating costs of $100,000. Assume the plane can be fully depreciated on a straight-line basis for tax purposes over 10 years. The company’s weighted average cost of capital (commonly referred to as WACC) is 8%, and its corporate tax rate is 40%. Does this endeavor present a positive or negative net present value (NPV)? If positive, how much value is being created for the company through the purchase of this asset? If negative, what additional annual cash flows would be needed for the NPV to equal zero? To what phenomena might those additional positive cash flows be ascribable?

Answer 1

	A	Initial Investment	$6,000,000
		Annual Cash Flow;
	B	Savings in annual expenses	$220,000
	C	Annual operating costs	($100,000)
	D=B+C	Annual before tax cash flow	$120,000
	E=D*(1-0.4)	After tax annualcash flow	$72,000
	F	Annual Depreciation	$600,000	(6000000/10)
	G=F*0.4	AnnualDepreciationtax shield	$240,000
	H=E+G	Totalannualcash flowfor 10years	$312,000
		WACC=8%
	I	Present Value of totalannualcash flow	$2,093,545	(Using PV function of excel with Rate=8%, Nper=10, Pmt=-312000)
	NPV=I-A	Net Present Value	($3,906,455)
		AdditionalCash Flow Required to make NPV=0
	J	Additional Present Value of annual cash flow	$3,906,455
	K	Additionalannual aftertax cash flow required	$582,177	(Using PMT function of excel with Rate=8%, Nper=10, PV=-3906455)
	L=K/(1-0.4)	AdditionalBefore tax positive cash flow required	$          970,295