Question

New-model commercial airplanes are much more fuel-efficient than older models. How is it possible for airlines flying older models to make money when their competitors are flying newer planes? When answering this question, consider capital budgeting. If the old planes still make money, does it make sense to buy new planes, given how long it would take to make the money back from the purchase of new planes? Explain thoroughly.

Answer 1

It is true that newer aircrafts are more fuel efficient but they also cost more and incur higher depreciation expense and thus the amortization of the higher initial cost partially offsets the benefits due to fuel efficiency. So an airline operating with older fleet of airlines can still make money if it is efficient and keep the operations cost effective.

For airlines, it is essential to acquire newer aircrafts with better fuel efficiency to replace their ageing fleets gradually and hence build competitive advanatge for the future. As long as the investments can be recovered in a reasonable amount of time and the incremental returns from the incremental savings are better than the cost of capital, then the investment should be undertaken to increase firm value.