Question

Charlie Brown is thinking about starting Wing-It Airlines to fly a commuter route in and out of a major city. Four planes are on the market that will do the job, but each has different flight, load, and operating characteristics. Charlie is unsure of the demand for his service, and feels that it may depend to some extent on the type of plane chosen. Whether or not the business is feasible may depend on which airplane is used in conjunction with the demand estimate assumed. Are capital budgeting techniques appropriate for analysis of this problem? If so, is the issue a stand-alone or mutually exclusive decision?

I need 300 to 350 words, Thanks.

Answer 1

Capital Budgeting is an investment appraisal tool used to determine whether to invest or not in an investment proposal. This takes into account the future Cashinflows generated from the proposal and the expected cashoutflows, comparing these two the decision is made.

In the given situation, Charlie brown is facing a question of whether the business is feasible or not and also which type of the plane is to be used (our of 4 available types).

We have to do capital budgeting process for the four types of plans with their respective costs, revenues and estimated demands, based on this the pane which gives the highest Net present value (NPV), Internal Rate of Return (IRR) is selected.

NPV = Net present Value = Present value of cash Inflows - Present value of cash outflows

(This NPV must be positive, to accept a project)

(The discounting is done based on the required rate of return i.e., WACC)

IRR = Internal rate of return (the implied rate of return that a project generates)

(This must be more than required rate of return or WACC in order to accept the project)

We have to make the decision of doing the business if we get Positive Cashflows only (that means the present value of cashinflows are higher than present value of cashoutflows). Also we will select that plane of the 4 available types which gives the highest Net Present Value based on our capital budgeting analysis. So we can say that capital budgeting analysis are appropriate for this types of problem.

Mutually exclusive means both cannot happen at a time. In investment opportunity terms, we cannot invest in both or more than one project or proposal at a time. Whereas Stand alone decision means the impact of decison on one project will not impact the decision making of other projects. That means we can invest in more than one projects at a time under this type.

The decision involved here is mutually exclusive decision. If we invest in one type of plane that means we are automatically rejecting the other types of planes.