Question

You are contemplating the purchase of a one-half interest in a corporate airplane to facilitate the expansion of your business into two new geographic areas. The acquisition would eliminate about $220,000 in estimated annual expenditures for commercial flights, mileage reimbursements, rental cars, and hotels for each of the next 10 years. The total purchase price for the half-share is $6 million, plus associated annual operating costs of $100,000. Assume the plane can be fully depreciated on a straight-line basis for tax purposes over 10 years. The company’s weighted average cost of capital (commonly referred to as WACC) is 8%, and its corporate tax rate is 40%. Does this endeavor present a positive or negative net present value (NPV)? If positive, how much value is being created for the company through the purchase of this asset? If negative, what additional annual cash flows would be needed for the NPV to equal zero? To what phenomena might those additional positive cash flows be ascribable?

Answer 1

Savings	220,000
Depreciation	-600,000
EBIT	-380,000
Tax (40%)	152,000
Profits	-228,000
Cash Flows	372,000

In this case, annual cash flows = Profits + Depreciation = 372,000, where depreciation = 6m / 10 = 600,000

Now, NPV = PV of annual cash flows for 10 years at 8% - Initial Investment

PV of annual cash flows can be calculated using PV function on a calculator

N = 10, PMT = 372,000, I/Y = 8%, FV = 0 => Compute PV = $2,496,150

NPV = 2,496,150 - 6,000,000 = -$3,503,850

As the NPV is negative, there is value destruction.

In order to have NPV = 0, use trial and error method to to calculate required cash flows.

If annual cash flows = $894,177, then NPV = 0. These additional positive cash flows should be a result of savings from current expenditure.