Question

Stan Mayfield, president of Mayfield Software, is interested in acquiring a used aircraft to facilitate business travel. The aircraft he is interested in will cost $ 1,000,000. It has a five life with an anticipated residual value of $ 600,000.

                Mayfield estimates that he and four other executives each take 100 trips per year at a cost of $550 per trip (they fly first class and, often, two or more of the executives fly together). The costs are expected to increase at 4 percent per year.

                If Mayfield buys the plane, a pilot will be hired at a cost of $85,000 per year. Fuel, maintenance, insurance and other operating costs will be $330,000 per year. This includes $80,000 of depreciation, but excludes the pilot’s salary. The pilot’s salary and operating costs (other than depreciation) will increase at 4 percent per year due to general inflation.

                Mayfield values the time he and other executives will save using a company plane at $500 per trip per person. He believes that the value of executive time will increase at least as fast as general inflation. The company tax rate is 40 percent and its required rate of return is 10 percent.

Required:

                Analyze the investment in the plane.

Answer 1

Step - 1 - Calculation of present value of cash outflow under present system
Years	-	1	2	3	4	5	Total
Cost of travelling		$ 2,75,000.00	$ 2,86,000.00	$ 2,97,440.00	$ 3,09,337.60	$   3,21,711.10
Less: Tax saving @ 40%		$ 1,10,000.00	$ 1,14,400.00	$ 1,18,976.00	$ 1,23,735.04	$   1,28,684.44
Net outflow		$ 1,65,000.00	$ 1,71,600.00	$ 1,78,464.00	$ 1,85,602.56	$   1,93,026.66
Present value		$ 1,55,660.38	$ 1,52,723.39	$ 1,49,841.82	$ 1,47,014.61	$   1,44,240.75	$ 7,49,480.94
Step - 2 - Calculation of present value of cash outflow if new aircraft is purchased
Outflow
Pilot salary		$      85,000.00	$      88,400.00	$      91,936.00	$      95,613.44	$       99,437.98
Fuel and other operating cost		$ 2,50,000.00	$ 2,60,000.00	$ 2,70,400.00	$ 2,81,216.00	$   2,92,464.64
Depreciation		$      80,000.00	$      80,000.00	$      80,000.00	$      80,000.00	$       80,000.00
Total Expenses		$ 4,15,000.00	$ 4,28,400.00	$ 4,42,336.00	$ 4,56,829.44	$   4,71,902.62
Less: Tax saving		$ 1,66,000.00	$ 1,71,360.00	$ 1,76,934.40	$ 1,82,731.78	$   1,88,761.05
Net expenses		$ 2,49,000.00	$ 2,57,040.00	$ 2,65,401.60	$ 2,74,097.66	$   2,83,141.57
less :depreciation		$      80,000.00	$      80,000.00	$      80,000.00	$      80,000.00	$       80,000.00
Netoutflow		$ 1,69,000.00	$ 1,77,040.00	$ 1,85,401.60	$ 1,94,097.66	$   2,03,141.57
Machinery	$      10,00,000.00
Total Outflow	$      10,00,000.00	$ 1,69,000.00	$ 1,77,040.00	$ 1,85,401.60	$ 1,94,097.66	$   2,03,141.57
Less: Inflow
Savings after tax		$ 1,50,000.00	$ 1,56,000.00	$ 1,62,240.00	$ 1,68,729.60	$   1,75,478.78
Residual value						$   6,00,000.00
Net outflow	$      10,00,000.00	$      19,000.00	$      21,040.00	$      23,161.60	$      25,368.06	$ -5,72,337.21
Present value	$      10,00,000.00	$      17,924.53	$      18,725.53	$      19,446.93	$      20,093.88	$ -4,27,683.66	$ 6,48,507.20
Decision:	since net outflow under new sysytem is low, it is profitable if we purchase aircraft