An airline is considering the purchase of an Airbus A-320neo which offers improv

Question

An airline is considering the purchase of an Airbus A-320neo which offers improved fuel efficiency over the previous generation of narrow-body aircraft. The finance department estimates the aircraft will generate a positive net cash flow of $6 million in the first year increasing by 5% annually owing to the aircraft’s fuel efficiency. The airline plans to operate the aircraft for 15 years, then selling it in year 16 for an estimated net cash price of $30 million. The airline targets a return on invested capital of 12% annually (use this rate rather than the interest rate to discount future cash flows). What is the maximum price the airline should be willing to pay for a new A-320neo? Note: This computation is easiest to perform using MS Excel. The Excel computations may be copied and pasted into MS Word.

Explanation / Answer

P = $6 Million

n = 15 years

Growth in annual net cash flow (g) = 5%

Discount Rate (R) = 12%

Salvage value = $30 Million

Then,

Maximum cash price to be paid for the Airline = Present value of all cash inflows

Present value of all cash inflows = Present Value of growing annuity + Present Value of salvage value

Present value of all cash inflows = (P/(R-g))*(1-((1+g)/(1+R))^n)   + 30 / (1+R)^n

Present value of all cash inflows = (6/(.12-.05))*(1-((1+.05)/(1+.12))^15)   + 30 / (1+.12)^15

Present value of all cash inflows = $58.639 Million or $58.64 Million

Thus, Maximum cash price to be paid for the Airline should be $58.64 Million approx.

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