An airline is considering two types of engines for use in its planes. Each engin

Question

An airline is considering two types of engines for use in its planes. Each engine has the same life, the same maintenance, and the same repair record.

Engine A costs $100,000 and uses 50,000 gallons of fuel per 1,000 hours of operation at the average service load encountered in passenger service.

Engine B costs $200,000 and uses 32,000 gallons of fuel per 1,000 hours of operation at the same service load.

Both engines are estimated to have 10,000 service hours before any major overhaul of the engines is required. If fuel currently costs $5.90 per gallon and its price is expected to increase at the rate of 8% because of inflation, which engine should the firm install for an expected 2,000 hours of operation? The firm’s marginal income-tax rate is 40%, and the engine will be depreciated on the basis of the unit-of-production method. Assume that the firm’s market interest rate is 20%. It is estimated that both engines will retain a market value of 40% of their initial cost (actual dollars) if they are sold on the market after 10,000 hours of operation.

(a) Using the present-worth criterion, which project would you select?

(b) Using the annual-equivalent criterion, which project would you select?

(c) Using the future-worth criterion, which project would you select?

Explanation / Answer

Ans:

Assumption Airlines fuel cost = $5.90

System A:

Equivalent annual fuel cost A = $5.90 gal * 50,000gals / 1,000 hours

10,000hrs = $2,950,000

AE (20%) = $2,950,000(P/A 8%, 20%, 3) (A/P, 20%,3)

= $3,186,000

AE (20%) = ($100,000 - $20,000) (A/P 20%,) + (0.20) ($20,000) + $3,186,000

= $4,141,800

System B:

Equivalent annual fuel cost A = $5.90 gal * 32,000gals / 1,000 hours

10,000 hrs = $1,888,000

AE (20%) = $1,888,000(P/A 8%, 20%, 3) (A/P, 20%,3)

= $2,039,040

AE (20%) = ($200,000 - $40,000) (A/P 20%,) + (0.20) ($40,000) + $2,039,040

= $2,650,752

Equivalent operating cost:

System A = $ $4,141,800

System B = $2,650,752

System B is better choice

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