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 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 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

1. Fuel consumption (gallons/flight between LA and NY)

2. Maintenance time (maintenance days/year)

3. Upgrading costs* (dollars/year of operation)

4. Capacity per plane

PJ-1 PJ-2 PJ-3

4,000 3,000 2,000 40 30 20

EXHIBIT 1 Fly-by-Night Airlines Operating Data on P&J Planes (expected value per plane)

100,000 50,000 200 250 350

16,666.67

* 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.

1. Passenger load factor

Economic Data for Los Angeles New York Route*

Plane

0.95 (drops to 0.92 after the PJ-2 PJ-1 or PJ-3 is introduced by the manufacturer) 0.90

0.82

Passenger load factor = average number of passengers per flight passenger capacity of plane

2. Number of one-way flights Los Angeles New York per year

300 PJ-1 320 PJ-2 335 PJ-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.

PJ-2 PJ-3

2

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

PJ-1 PJ-2 PJ-3

Appropriate Cost of Capital

10% 12% 15%

James Baron has decided to discount (calculate present values of) all plane purchase costs or salvage values at 15 percent. Finally, the firms marginal tax rate is 50 percent.

Question:

1. Compute the net present value for an option of not replacing and using old PJ-1s for the next 15 years.

2. 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)?