Adams County’s Board of Representatives is considering the construction of a lon
ID: 2475308 • Letter: A
Question
Adams County’s Board of Representatives is considering the construction of a longer runway at the county airport. Currently, the airport can handle only private aircraft and small commuter jets. A new, long runway would enable the airport to handle the midsize jets used on many domestic flights. Data pertinent to the board’s decision appear below.
In addition to the preceding data, two other facts are relevant to the decision. First, a longer runway will require a new snowplow, which will cost $200,000. The old snowplow could be sold now for $20,000. The new, larger plow will cost $19,000 more in annual operating costs. Second, the County Board of Representatives believes that the proposed long runway, and the major jet service it will bring to the county, will increase economic activity in the community. The board projects that the increased economic activity will result in $136,000 per year in additional tax revenue for the county.
In analyzing the runway proposal, the board has decided to use a 10-year time horizon. The county’s hurdle rate for capital projects is 25 percent.
Cost of acquiring land
Annual cost of maintaining new runway
Annual incremental revenue from landing fees
Cost of new snow plow
Cost of runway lights
Annual additional tax revenue
Salvage value of old snow plow
Cost of acquiring land
Annual cost of maintaining new runway
Annual incremental revenue from landing fees
Cost of new snow plow
Cost of runway lights
Annual additional tax revenue
Salvage value of old snow plow
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Which of the following statements are true? (Select all that apply.)
Adams County’s Board of Representatives is considering the construction of a longer runway at the county airport. Currently, the airport can handle only private aircraft and small commuter jets. A new, long runway would enable the airport to handle the midsize jets used on many domestic flights. Data pertinent to the board’s decision appear below.
Explanation / Answer
3a. The cost of acquiring land is likely to be most uncertain. This is because, unlike other assets, determining the value and price of a piece of land is very difficult. The value of a land is its actual worth, in relation to other similar properties. However, the commerical transactions (buying and selling) of land is influenced by several factors, which in turn determines the price of a piece of land. Factors like demand for the land can be highly volatile as well as dynamic, so unless and until the land is purchased or a contract is entered into, its price will be uncertain.
b. As the county airport already has a runway, it will have a fair idea about the costs of maintaining a new runway (it can be benchmarked against the costs of the existing runway). Secondly, annual incremental revenue will be a function of the number of extra planes landing due to the new runway. This figure will also be certain as the airport can easily calculate the additional traffic that will increase due to the new runway. Cost of runway lights will also be certain as the airport must already be using runway lights for the old runway and must have obtained current price for lights. Similarly (and using the same logic that was used for lights), the cost of new snowplow will also be certain.
Thus the answer is - Annual cost of maintaining new runway, Annual incremental revenue from landing fees, Cost of runway lights and Cost of new snow plow.
c. The following statements are true -
(i) The net-present-value method is preferable to the payback method. This is because the payback period does not take into account the time value of money. The NPV method considers the time value of money and hence is a more scientific and prudent method.
(ii) The payback period criterion fails to account for the time value of money. Payback period measures the length of time that is required to recover the initial cash outlay. For example if the initial outlay was $1,000,000 and has a constant annual inflow of $30,000 per year, then the payback will be = 1,000,000/30,000 = 3.33 years. But there is no consideration of time value of money.
(iii) The cut-off value for the payback period has nothing to do with the bank's hurdle rate. Under the payback method, the shorter the payback period, the more desirable the project is. Hurdle rate is used to discount cash flows to take into account time value of money. So, hurdle rate has no application in the payback method or its cut off value. (The cut off value in payback method will be a time period).
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