Question

Shao Airlines is considering the purchase of two alternative planes. Plane A has an expected life of 5 years, will cost $100 million, and will produce net cash flows of $29 million per year. Plane B has a life of 10 years, will cost $132 million and will produce net cash flows of $24 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares are expected to be zero, and the company's cost of capital is 8%.

1. By how much would the value of the company increase if it accepted the better project (plane)? Enter your answer in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Do not round intermediate calculations. Round your answer to two decimal places.

   $   million

2. What is the equivalent annual annuity for each plane? Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Do not round intermediate calculations. Round your answers to two decimal places.

   Plane A: $   million

   Plane B: $   million

Answer 1

a. We will calculate Net Present Value to find out the better alternative for the Airlines.

Net Present Value is difference of Present Value of cash inflows and Present Value of cash outflows.

For Plane A,

Cash outflow or initial investment is $100 million.

Cash inflow is $29 million over 5 years period.

For Plane A,

Cash outflow or initial investment is $132 million.

Cash inflow is $24 million over 10 years period

NPV of Plane A is $15.79 million

NPV of Plane B is $29.04 million

NPV of Plane B is greater than NPV of Plane A, hence Plane B will be accepted.

Increase in value by accepting plane B over Plane A is = $29.04 - $15.79 = $ 13.25 million

b. Equivalent Annual Annuity

EAA :

Plane A : $ 3.95 million

Plane B : $ 4.33 million