Fly-by-Night Airlines

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 and to $3 million by the end of the sixth 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 assist him in making this decision, James Baron wants to know the net present values of three different investment options. For all options, he is using 15-year planning horizon. Under option A, 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 the remainder of the horizon12 years. Option B is the same as option A, except that rather than continuing to use PJ-2s for the remainder of the horizon, these planes will be replaced at the end of the sixth year by the PJ-3s, which will then be used for the remainder of the horizon9 years. Under option C, the firm will continue to use its current fleet of PJ-1s for 6 years, replace them with PJ-3s at the end of the sixth year, and use these PJ-3s for the remainder of the horizon9 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 in 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.

EXHIBIT 1

Fly-by-Night Airlines

Operating Data on P&J Planes (expected value per plane)

PJ-1

PJ-2

PJ-3

1.

Fuel consumption (gallons/flight between LA and NY)

4,000

3,000

2,000

2.

Maintenance time (maintenance days/year)

40

30

20

3.

Upgrading costs* (dollars/year of operation)

100,000

50,000

16,666.67

4.

Capacity per plane

200

250

350

* Includes expenses for noise and pollution reduction, safety improvements, etc. The figures for the PJ-2 apply to the end of year 4, and those for the PJ-3 to the end of year 7.

EXHIBIT 2

Fly-by-Night Airlines

Economic Data for Airline Industry

1.Fuel costs will be $0.55 per gallon by year-end and will grow at a constant expected annual rate of 9% per year.

2.For all planes: by year-end maintenance costs will be $60,000 per day the plane is in maintenance. Maintenance costs will grow at a constant expected annual rate of 5% per year.

3.Upgrading costs will grow at a constant expected annual rate of 8% per year for each plane.

Economic Data for Los Angeles - New York Route*

1.Passenger load factor

Plane

0.95 (drops to 0.92 after the PJ-2 or PJ-3 is introduced by the manufacturer)

PJ-1

0.90

PJ-2

0.82

PJ-3

2.Number of one-way flights

Los Angeles - New York per year

300PJ-1

320PJ-2

335PJ-3

3.The average price of a one-way ticket between Los Angeles and New York will be $400 by year-end and is expected to grow at a constant annual rate of 4%. The ticket price remains the same regardless of which plane is used.

4.Personnel and administrative expenses (e.g., pilot, flight attendant, ticket agent salaries) are currently, and are expected to continue to be, 77% of ticket revenues.

* All figures for which growth rates are not specified are assumed to remain constant over time.

The differences in number of flights per year are due to differences in time spent on maintenance and upgrading.

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.

James Baron has made a list of other information that he feels is relevant to this decision. First, to retain a license for the Los Angeles - New York route, airlines are required by a federal government regulatory agency to allocate enough aircraft to the route to service a minimum of 300,000 passengers per year. Second, since both the PJ-2 and PJ-3 aircraft have not yet been used in commercial service, their cost and operating figures are likely to be more uncertain than those for the PJ-1at least until the bugs are eliminated. For this reason, James Baron has decided to use a larger risk-adjusted discount rate or cost of capital for the expected cash flows generated by the PJ-2 and PJ-3 planes. His choices of discount rates are:

Plane

Appropriate Cost of Capital

PJ-1

10%

PJ-2

12%

PJ-3

15%

James Baron has decided to discount all plane purchase costs or salvage values at 15 percent. Finally, the firm's marginal tax rate is 50 percent.

QUESTIONS

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 have thecapabilityof 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 larger-capacity 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 for option A. 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. 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 costs, etc.

3.Compute the net present value for option B in a similar fashion.

4.Compute the net present value for option C in a similar fashion.

5.What would happen to the NPV of each option if the rate of inflation increased? (No calculation necessary, briefly explain.)

6.Which investment option is more valuable and what should James Baron do if he wants to maximize the shareholders' value?