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 flow of $30 million per year. Plane B has a life of 10 years, will cost $132 million, and will produce net cash flows of $25 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company's cost of capital is 12%. By how much would the value of the company increase if it accepted the better project (plane)? What is the equivalent annual annuity for each plane?

Show steps solving the problem.

Answer 1

Increase in value of company = NPV of project

NPV = present value of cash inflows - initial investment

Present value of each cash inflow = cash inflow / (1 + cost of capital)ⁿ

where n = number of years after which the cash flow occurs.

Equivalent annual annuity = (NPV * r) / (1 - (1 + r)^-n)

where r = cost of capital

n = life of project in years

Project B has a higher NPV. However, Project A has a higher EAA.

In this case, Project A should be accepted. When comparing projects with unequal lives, EAA is the appropriate measure. NPV of both projects cannot be compared directly because they have unequal lives.

Project A is the better project. If is accepted, the value of the company would increase by $8,143,286