For long distance transport of your expensive electronic products your company i
ID: 2739429 • Letter: F
Question
For long distance transport of your expensive electronic products your company is leasinga cargo-plane for $150,000 per year. Your annual costs depend on the miles of flights andthey are directly proportional to them at a cost of $5 per mile.
You have received an offer to purchase an airplane
- Initial investment of $1,000,000.
- The lifespan of the airplane is 8 years at which time it can be scrapped for $150,000.
- At 5 years a major maintenance of cost $150,000 will be required. Obviously at the end you do not have to perform maintenance.
- Due to its technological improvements the cost per mile is $4.6.
Evaluate the proposed offer using the net present value for an indicative annual mileage of 120,000 miles.
What is the Internal Rate of Return of the purchase versus the continuation of the lease? Do you recommend it? The discount interest rate (MARR) for the evaluation of the investments is set to 4%.
Explanation / Answer
a. Computation of the net present value:
Proposed offer:
Present value of cash outflows at 4% discount rate = $ 1,000,000 + $ 150,000 x PVIF 4%, 5years + 120,000 x $ 4.6 x PVIFA 4%, 8 years =1,000,000 + 150,000 x 0.8219 + 552,000 x 6.7327 = $ 1,000,000 + $ 123,285 + $ 3,716,450 = $ 4,839,735
Present value of cash inflows = $ 150,000 x PVIF4%, 8th year = $ 150,000 x 0.7307 = $ 109,605
Net present value of cash ouflows of the proposed offer = $ ( 109,605 - 4,839,735) = $ 4,730,130
Existing leasing arrangement:
Present value of cash outflows = $ ( 150,000 + 120,000 x 5) x PVIFA 4%, 8 years= $ 750,000 x 6.7327 = $ 5,049,525
Net present value of the proposed offer = $ ( 5,049,525 - 4,730,130) = $ 319,395
b. Internal rate of return:
Annual savings in operating costs per annum = $ 750,000 - $ 552,000 = $ 198,000
Net investment = $ 1,000,000 + $ 150,000 - $ 150,000 + $ 1,000,000
PV factor = $ 1000,000 / $ 198,000 = 5.05051
IRR is about 11.2%
As the IRR is higher than the MARR, the proposed offer of purchasing the airplane is recommended.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.