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Solutions Manual to accompany Principles of Corporate Finance (8th Edition)

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Problem

The world airline system is composed of the routes X and Y, each of which requires 10 aircraft. These routes can be serviced by three types of aircraft—A, B, and C. There are 5 type A aircraft available, 10 type B, and 10 type C. These aircraft are identical except for their operating costs, which are as follows:

  Annual Operating Cost ($ millions)

Aircraft Type Route X Route Y

A 1.5 1.5

B 2.5 2.0

C 4.5 3.5

The aircraft have a useful life of five years and a salvage value of $1 million.

The aircraft owners do not operate the aircraft themselves but rent them to the operators. Owners act competitively to maximize their rental income, and operators attempt to minimize their operating costs. Airfares are also competitively determined. Assume the cost of capital is 10%.

a. Which aircraft would be used on which route, and how much would each aircraft be worth?

b. What would happen to usage and prices of each aircraft if the number of type A aircraft increased to 10?

c. What would happen if the number of type A aircraft increased to 15?

d. What would happen if the number of type A aircraft increased to 20?

State any additional assumptions you need to make.

Step-by-step solution

Equilibrium refers to the state in which the market demand is equal to the market supply. This situation leads to a level where prices are stable.

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The competitive price is the price of a product based upon the competition. Competitive prices are charged by the business players in similar industry.

Comment

The airline system is composed of two routes, X and Y, and each route requires 10 aircrafts. There are 5 types of A aircraft, 10 types of B and 10 types of C. Useful life is five years and salvage value is $1 million. Cost of capital is 10%.

The operating costs for aircrafts are as follows:

Aircraft Type Annual Operating cost ($ millions)

Route X Route Y

A 1.5 1.5

B 2.5 2

C 4.5 3.5

Comment

Computation of price of Type – A and Price B:

The following are the important issues in computation of price of Type – A and B:

(a) The aircraft will be deployed in a manner that will minimize costs. That is, each aircraft will be used on the route for which it has the greatest competitive advantage.

(b) It will be assumed that Route X is served with five Type – As and five Type – Bs and Route Y is served with five Type – Bs and five Type – Cs.

(c) The balance of Type – C aircrafts will be scrapped.

(d) The maximum price to pay for the aircraft is the additional cost to be incurred if the aircraft is not serviced regularly.

Comment

Formula to calculate present value is as follows:

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The value of PVIFA can be known from the PVIFA table for 10% at 5th year.

Comment

The present value of the operating costs at 10% cost of capital for five years will be computed as below:

Aircraft Type Annual Operating cost ($ millions)

Route X Route Y

A

B

C

Comment

Computation of cost of using Aircrafts:

Type – A:

This cost must be equal to the cost of using a Type – B aircraft in Route X.

Therefore,

Comment

Type – B:

This cost must be equal to the cost of using a Type – C aircraft in Route Y.

Therefore,

Since the five types of aircrafts are scrapped for $1 million, the price of Type – C aircraft is $1 million.

Calculate the Price of Type – B aircraft as follows:

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Recommended solutions for you in Chapter 12

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Calculate the Price of Type – A aircraft as follows:

Comment

Therefore, the price of Type – B will be $6.69 million, and that of Type – A is $10.48 million.

Comment

Using the above figures, the solutions will be given as follows:

Question Route

X

Usage

Y Scrap Aircraft value (in $ millions)

A B C

(a) 5A+5B 5B+5C 5C 10.48 6.69 1.00

(b) 10A 10B 10C 10.48 6.69 1.00

(c) 10A 5A+5B 5B+10C 2.90 1.00 1.00

(d) 10A 10A 10B+10C 2.90 1.00 1.00

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Chapter 12, Problem 10

Thanks to acquisition of a key patent, your company now has exclusive production rights for barkelgassers (BGs) in North...

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