isand Airlines Inc. needs to replace a short-haul commuter plane on one of its busier routes. Two aircraft are on the market that satisfy the general requirements of the route. One is more expensive than the other but has better fuel efficiency and load-bearing characteristics, which result in better long-term profitability. The useful life of both planes is expected to be about seven years, after which time both are assumed to have no value. Cash flow projections for the two aircraft follow.
Low Cost | High Cost | |
Initial cost | $775,000 | $950,000 |
Cash inflows, years 1 through 7 | 154,000 | 176,275 |
Low Cost | High Cost | ||
2% | NPV | $ | $ |
PI | |||
4% | NPV | $ | $ |
PI | |||
6% | NPV | $ | $ |
PI | |||
8% | NPV | $ | $ |
PI | |||
10% | NPV | $ | $ |
PI |
NPV=Present value of future cashinflows-Initial cost
NPV can be found by NPV function in EXCEL
NPV(rate,Year1 to Year7 cashflows)-Initial cost
PI=Present value of future cashinflows/Initial cost
EXCEL formula is,
NPV(rate,Year1 to Year7 cashflows)/Initial cost
The findings are mentioned in the below sheet.
Based on NPV and PI, we should select Lowcost plane as it has positive NPV and PI greater than 1. But for 10% cost of capital, both the projects have negative NPV and PI lower than 1. Hence, better to avoid at only 10% cost of capital. But at other cost of capital like 2%,4%,6% and 8%, Lowcost plane should be selected.
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