Finance-It is the end of the financial year and the management team of Tiger Air

| January 31, 2017

It is the end of the financial year and the management team of Tiger Air, a budget airline that provides short-haul flights in the South-East Asia region, is reviewing the functionality of its aircraft. It has come to the airline’s attention that one of its aircraft has experienced a considerable amount of down time and is in need of an overhaul. The overhaul is expected to cost a total of $3 million, including $2 million for engine replacement, $400,000 for safety devices, $200,000 for new carpet and seating, and $200,000 for repainting the aircraft. After the overhaul, it is expected that the aircraft will have a useful life of five years, at which time it can be sold for a salvage value of $300,000. Until the aircraft is scrapped, the annual operating cost, including fuel, will be $1,500,000. It is also agreed that the cost of the overhaul, except for the painting expense, will be recorded as an investment (in the accounting book), to be depreciated using the straight-line method over the remaining useful life of the aircraft. The cost of painting, on the other hand, will be treated as an expense that produces an immediate tax benefit.

Parallel to the overhaul option, the management team is also considering the purchase of a new aircraft. If a new aircraft is purchased, the existing aircraft will have to be scrapped in the current condition at approximately $750,000. The new aircraft will cost $7,500,000 but will be longer lasting, having an estimated useful life of 10 years. This new aircraft is expected to be more efficient in fuel consumption and therefore the annual operating cost is estimated to be $900,000. The new aircraft will also be depreciated for accounting purposes using the straight-line method down to zero, while management is hoping to fetch a salvage value of $800,000 for the aircraft.

Tiger Air’s existing after-tax cost of capital is 8%, which is deemed to be appropriate for a capital-budgeting decision of this nature. The tax rate that the company faces is 30%. Calculate the equivalent annual cost for the overhaul versus purchase option and advise Tiger Air on the most economically viable course of action.

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