Fly-by-Night Airlines is a major commercial
air carrier offering passenger service between
most large cities in the United States. One of its more profitable routes is between Los Angeles and
New York. Competition on this route is intense, and James Baron, supervisor of transcontinental
operations for Fly-by-Night, is considering upgrading the quality of the fleet of aircraft used on the
Los Angeles - New York run.
As it has in the past, Fly-by-Night plans to purchase all its planes from P&J Aircraft
Company. P&J markets three aircraft: (1) the old reliable PJ-1, for the last ten years the workhorse
of the airline industry; (2) the soon-to-be-introduced PJ-2, currently in the test flight stage; and (3)
the technologically advanced PJ-3, still in the design stage. Although PJ-2 and PJ-3 will not be
available for service until sometime in the future, P&J is now taking contingency orders for these
planes. If Fly-by-Night is to have any hope for prompt delivery, it must order the planes today, even
though it will not take delivery or pay for them until sometime in the future. Fly-by-Night is very
interested in the newer models because they are more fuel efficient and less polluting, require less
maintenance, and are much quieter than the old PJ-1.
Fly-by-Night currently uses five PJ-1 planes to service its Los Angeles - New York route.
These planes were purchased 10 years ago for a cost of $15 million per plane; each is being
depreciated on a straight-line basis to a salvage value of zero over a 25-year economic life from the
date of purchase. Each PJ-1 plane could be sold currently at a market value of $8 million. This
market price for the PJ-1 is expected to drop to $5 million by the end of third year.
James Baron is considering replacing the PJ-1 planes with either the PJ-2 or the PJ-3. The
PJ-2 will be available for delivery in three years and could generate its first cash flow from
commercial service in the fourth year. The PJ-3 will be available for delivery in six years and could
generate its first cash flow in the seventh year.
To make an informed decision, James Baron wants to know the NPV of the replacement
option. He is using 15-year planning horizon for his analysis. Under this replacement option, the
firm will continue to use the PJ-1s for three more years, replace them with the PJ-2s at the end of
the third year and use these PJ-2s for 3 years after that, and then replace the PJ-2s with the PJ-3s at
the end of the sixth year, which will then be used for the remainder of the horizon—9 years.
The purchase price for PJ-2 three years from now will be $20 million. This cost will be
depreciated on a straight-line basis over 12 years to a salvage value of $8 million. The PJ-2 is
expected to have a market value at the end of the sixth year of $18 million. Six years from now,
when the PJ-3 becomes available, it will cost $30 million per plane and will be depreciated on a
straight-line basis over nine years to a salvage value of $12 million.
To assist him in making this decision, James Baron has obtained the data shown in Exhibits
1 and 2 from aerospace engineers at P&J and from transportation economists at Fly-by-Night. The
passenger load factors come from a careful analysis of future demand and supply conditions and the
degree of competition on the Los Angeles - New York route. Fly-by-Nights transportation
economists feel that it is quite likely that the major competitors serving this route will eventually all
convert to the newer aircraft and that, to remain competitive, Fly-by-Night will eventually have to
do the same. They are uncertain whether the PJ-2 or PJ-3 will become the more popular plane, but
they feel that correctly guessing which plane will gain long-run acceptance by the flying public may
be the key to any change in market share on this route. The future price of fuel is likely to be the
key determinant of the future relative efficiency of these two panes. In general, however, the
economists believe it will be very difficult for firms operating the Los Angeles - New York run to
change their market share substantially in the future.
1. If Fly-by-Night decides to upgrade its fleet by using the PJ-2 exclusively, how many PJ-2 planes will it
need to buy to meet the federal government regulation requiring that an airline serving the Los Angeles
- New York route has the capability of carrying a minimum of 300,000 passengers per year? If the
company decides to use PJ-3 exclusively, how many PJ-3 planes will it need to buy to meet this federal
regulation? (Notice that the actual number of passengers that Fly-by-Night expects to carry is slightly
higher if it uses the PJ-2 or PJ-3 than it presently carries using the PJ-1. The reason is that the largercapacity
planes will allow it to eliminate some of the overbooking problems it now faces with the PJ-1
during holiday periods. However, management feels that Fly-by-Night cannot significantly increase its
ridership by buying increased capacity.)
2. Compute the net present value of the replacement option. First compute the ticket revenues that would
be generated in each year over the 15-year horizon. Then compute the total operating costs that would
be generated in each year over the same horizon. Operating costs include fuel, maintenance, upgrading,
and personnel expenditures. Then estimate the depreciation charges and taxes. Finally, compute the
total cash flow for each year. If the firm suffers a loss in any year in its Los Angeles - New York
operations, assume that it has other income in that year from which the loss can be deduced for tax
purposes. Don't forget to add purchases of new planes and after-tax salvage values of old planes and
other relevant incremental cash flows, e.g., opportunity cost of using currently owned PJ-1s, etc.
3. What would happen to the NPV of the replacement option if Fly-by-Night uses accelerated
depreciation instead of straight-line depreciation? (No calculation necessary, briefly explain.)
4. What would happen to the NPV of the replacement option if the rate of inflation increases? (No
calculation necessary, briefly explain.)
5. Compute the net present value for an option of not replacing and using old PJ-1s for the next 15 years.
6. Should James Baron go with the replacement option? What is the incremental NPV of the replacement
decision (difference between the replacement option NPV as in part 2 and the not replacing option
NPV as in part 5)?
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