Question

Question 4. Answer the following problem based on the Corporate Financial Analysis textbook. Your answer should be formatted similarly to Figure 13-1 on page 403 of that textbook. (25 pts)

Dinsmore Artists International is in the business of managing “pop” artists in the entertainment industry. It is considering the purchase of an executive jet plane to transport its executives and the artists it represents to various meetings and performance sites. It expects that by owning its own executive jet, it can save $1,400,000 the first year of operation for expenses that it would otherwise incur for buying seats on commercial flights or for chartering flights. It expects that the annual growth in savings would be 10%.

            The choice has narrowed down to two planes: the Aero Commander and the Super Eagle. Both provide the same savings and the same basic service (e.g., the same passenger and luggage capacity, flight speed, and maximum altitude of operation).

            The Aero Commander jet sells for $4,500,000. Its normal operating expenses would be $290,000 the first year and would increase 8% per year thereafter. In addition, there would be a cost of $350,000 for a major engine overhaul at the end of the third year. The cabin noise level in the Aero Commander is lower than in the Super Eagle, and its seats are somewhat more comfortable.

            The Super Eagle jet sells for $3,750,000. Its normal operating expenses would be $325,000 the first year and would increase 8% per year thereafter. In addition, there would be major engine overhauls at the end of the second and fourth years, each of which would cost $300,000.

            Dinsmore uses a WACC or discount rate of 10% and a reinvestment rate of 12% to value its investments in fixed assets. Tax rates are 38% for regular income and 25% for capital gains or losses.

            The jet purchased would be paid for and put into service during the first quarter of Dinsmore’s financial year. It would be depreciated according the appropriate MACRS schedule from (i.e., 7-year life with first-quarter convention).

            Dinsmore expects to sell whichever plane it chooses at the end of the fifth year for 20% of its purchase price.

* * * * * * * * * *

1. What is the net present value, internal rate of return, and modified internal rate of return associated with each of the two jet planes? Based on these values, what action do you recommend Dinsmore to take?

2. What non-financial information should Dinsmore take into consideration before making its final decision? Why might the information be important in Dinsmore’s decision? How might this information change the decision in part 1?

Answer 1

1
	Year	PVF@10%	Aero Commander Jet	PV amount	Super Eagle Jet	PV amount
Cost	0	1	4,500,000	4,500,000	3,750,000	3750000
operating expenses increase 8% per year with Net of Tax i.e exp (1-.38)	1	0.91	179,800	163,618	201,500	183365
	2	0.826	194,184	160,396	217,620	179754.12
	3	0.751	209,719	157,499	235,030	176507.2296
	4	0.683	226,496	154,697	253,832	173367.2341
	5	0.621	244,616	151,906	274,139	170240.0243
engine overhaul at the end of the third year Net of tax	3	0.751	217000	162,967
engine overhauls at the end of the second and fourth years	2	0.826			186,000	153636
	4	0.683			186,000	127038
Net Cash in flow on sale of asset	5	0.621	900000	-558,900	750000	-465750
Tax Savings on Depn	.1-5	3.791	195428.5714	-740,870	162857.1429	-617391.4286
Present Value				4,151,313		3,830,766
Note Assumed Depn SLM So no tax on salvage Value
reinvestment rate of 12% to value its investments in fixed assets
Tax rates are 38% for regular income and 25% for capital gain
sell 20% of its purchase price
Depn 7 year
W.N 1 Cash flow on Depn
Tax savings on Depn			195428.5714		162857.1429
Sell 20% of its purchase price at 5th year end	5		900000		750000
2.Internal rate of return where cash inflow & Outflow is Zero	0			4,151,313			3,830,766
		19%		PV @19	PV @30	PV amount@30	PV @33	PV @33
Savings in amount with 10% increase in price	1	0.84	1400000	1176000	0.769	1076600	0.751	1051400
	2	0.706	1540000	1087240	0.592	911680	0.565	870100
	3	0.593	1694000	1004542	0.455	770770	0.425	719950
	4	0.499	1863400	929836.6	0.35	652190	0.319	594424.6
	5	0.419	2049740	858841.06	0.269	551380.06	0.24	491937.6
				5056459.66		3962620.06		3727812
IRR for Aero
.=19%+{(5056459-4151313)/5056459-3962620}*(30-19)=28.1%
IRR for Super Eagle
.=30+(3962620-3830766)/(3962620-3727812)*3
0.3143