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Comparing two projects with unequal lives

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Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million and will produce net cash flows of $32 million per year. Plane B has a life of 10 years, will cost $132 million and will produce net cash flows of $26 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company's cost of capital is 14 percent.

1) By how much would the value of the company increase if it accepted the better project (plane)?
2) What is the equivalent annual annuity for each plane?

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Solution Preview

Please refer attached file for better clarity of functions used in MS Excel.

1) By how much would the value of the company increase if it accepted the better project (plane)?

Case - Plane A
Plane A has a life of 5 years. Shao plans to serve only for 10 years. So, Plane A will again be purchase at the end of 5 years which will serve till the end of 10th year.

Cash flows associated with this plan will be as under
Year Cash Flow ($ million) Description
0 -100 Initial outlay
1 32 Annual net cash inflow
2 32 Annual net cash inflow
3 32 Annual net cash inflow
4 32 Annual ...

Solution Summary

Solution describes the steps to estimate net addition to the company's value if the better plane is selected. Calculations are carried out with the help of suitable functions in MS Excel.

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