The president’s executive jet is not fully utilized. You judge that its use by o

Question

The president’s executive jet is not fully utilized. You judge that its use by other officers
would increase direct operating costs by only $20,000 a year and would save $100,000 a year
in airline bills. On the other hand, you believe that with the increased use the company will
need to replace the jet at the end of three years rather than four. A new jet costs $1.1 million
and (at its current low rate of use) has a life of six years. Assume that the company odes not
pay taxes. All cash flows are forecasted in real terms. The real opportunity cost of capital is 8
percent. Should you try to persuade the president to allow other officers to use the airplane?

Explanation / Answer

We choose between one of two situations. First option is to let other managers use the jet. That gives 80,000 net cash flow for three years but we have to buy airplane one year earlier. Second option is to save nothing but buy the plane after four years. Note that in both situations we assume that after we buy a new play we do not allow junior managers to use it. If it occurs that more intensive usage of the current jet is a good idea, maybe also it should be done with the next jet. But to prove this we must now how the jet depreciates when it is used more intensively since it is new. We do not have such data so that is why the question is only about the current jet. In the first situation the present value of savings is: PV(savings) = 80,000/1.08+80,000/(1.08)^2+80,000/(1.08)^3 = 206,168 The cost for making these savings is the need to spend money for a new aircraft one year earlier. In other words we pay equivalent annual cost of the jet for one extra year. EAC of a jet that lives six years is: EAC = 1100/(1/0.08 – 1/0.08 *1/1.08^6) = 237,941 It is born in the fourth year so we must discount it to the present to compare with savings: PV (EAC) = 237,941/1.08^4 = 174,894 Because present value of costs is smaller than present value of savings we should allow other managers to use the jet. We do not have to calculate anything to evaluate the second option because its value for first four periods is already set to zero

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