Aircraft Equipment LLC is considering two investment initiatives for 2014. The f
ID: 2647865 • Letter: A
Question
Aircraft Equipment LLC is considering two investment initiatives for 2014. The first (initiative #1) is to purchase a fleet of six helicopters for $30 million. These can be leased to a long-time client under a ten year contract to generate $3 million per year in incremental cash flow. The second (initiative #2) is to purchase a short-haul passenger plane for $100 million. Once leased to customers, this will yield $20 million per year in additional cash flow for the next ten years. After 10 years, the plane can be sold on the secondary market for $30 million. Aircraft leases are paid annually in advance. The firm
Explanation / Answer
Aircraft Equipment LLC
Calculation of NPV and Discounted Payback Period of Initiative -1
Year (n)
Cash Flow ($ in Millions)
PVF @ 4 % PVF= 1/(1+r)n-1
Discounted Cash Flow
Cumulative Discounted Cash Flow @ 4%
PVF @ 10 %
DCF @10 %
0
(30)
1.0
(30)
-30
1.0
-30
1
3
1.0
3
-27
1.0
3
2
3
0.96
2.88
-24.12
0.91
2.73
3
3
0.92
2.77
-21.34
0.83
2.48
4
3
0.89
2.67
-18.67
0.75
2.25
5
3
0.86
2.56
-16.11
0.68
2.05
6
3
0.82
2.47
-13.64
0.62
1.86
7
3
0.79
2.37
-11.27
0.56
1.69
8
3
0.76
2.28
-8.99
0.51
1.54
9
3
0.73
2.19
-6.80
0.47
1.40
10
3
0.70
2.11
-4.69
0.42
1.27
(4.69)
(9.72)
NPV of Initiative @ 4 % = -4.69
As NPV is negative no discounted payback period for Initiative-1
Calculation of NPV and Discounted Payback Period of Initiative -2
Year (n)
Cash Flow ($ in Millions)
PVF @ 4 % PVF= 1/(1+r)n-1
Discounted Cash Flow
Cumulative Discounted Cash Flow
PVF @ 10 %
DCF @10 %
CDCF@10%
0
(100)
1.0
(100)
-100
1.0
-100
-100
1
20
1.0
20
-80
1.0
20
-80
2
20
0.96
19.23
-60.77
0.91
18.18
-61.82
3
20
0.92
18.49
-42.28
0.83
16.53
-45.29
4
20
0.89
17.78
-24.50
0.75
15.03
-30.26
5
20
0.86
17.10
-7.40
0.68
13.66
-16.60
6
20
0.82
16.44
9.04
0.62
12.42
-4.18
7
20
0.79
15.81
24.84
0.56
11.29
7.11
8
20
0.76
15.20
40.04
0.51
10.26
17.37
9
20
0.73
14.61
54.65
0.47
9.33
26.70
10
20
0.70
14.05
68.71
0.42
8.48
35.18
10
30
0.68
20.27
88.97
0.39
11.57
46.75
88.97
46.75
Discounted Payback period of Initiative -2
= Last period having negative CDCF +( Absolute value of last negative CDCF / DCF of Next Year)
=5 Year + (7.4/16.44)
Discounted Payback period= 5.45 Year @ 4 %
=6 year +(4.18/11.29)
Discounted Payback period= 6.37 year @ 10 %
Note- Because lease rentals are received in advance hence formula of PVF has been modified as below
Formula of PVF= 1/(1+r)n
Modified Formula= 1/(1+r)n-1
But in case of initiative -2 where passenger plane sold in the secondary market at the end of 10th year original formula is used to determine PVF for present value of resale.
Decision
As NPV of Initiative -2 when cost of capital is 4 % is positive hence initiative-2 is to be accepted
At 10 % cost of capital also the decision remains same as NPV of initiative-2 is positive in this case too compare to initiative-1.
Internal Rate of Return ( IRR)
IRR is the discount rate which the NPV of a project becomes zero.
By trial and error method we calculate the IRR of a project. By changing discount rate till NPV becomes zero. This rate will be IRR.
If IRR is less than cost of capital project should be rejected.
By observing initiative-2 it is appearing that at 4% NPV is 88.97 while at 10 % 46.75 hence its IRR will be more than 10 %
Year (n)
Cash Flow ($ in Millions)
PVF @ 4 % PVF= 1/(1+r)n-1
Discounted Cash Flow
Cumulative Discounted Cash Flow @ 4%
PVF @ 10 %
DCF @10 %
0
(30)
1.0
(30)
-30
1.0
-30
1
3
1.0
3
-27
1.0
3
2
3
0.96
2.88
-24.12
0.91
2.73
3
3
0.92
2.77
-21.34
0.83
2.48
4
3
0.89
2.67
-18.67
0.75
2.25
5
3
0.86
2.56
-16.11
0.68
2.05
6
3
0.82
2.47
-13.64
0.62
1.86
7
3
0.79
2.37
-11.27
0.56
1.69
8
3
0.76
2.28
-8.99
0.51
1.54
9
3
0.73
2.19
-6.80
0.47
1.40
10
3
0.70
2.11
-4.69
0.42
1.27
(4.69)
(9.72)
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