Dinsmore Artists International
is in the business of managing singers and other artists in the entertainment
industry. It is considering the purchase of an executive jet plane to transport
its executives and the artists it represents to various meetings and
performance sites. It expects that by owning its own executive jet, it can save
$1,400,000 the first year of operation for expenses that it would otherwise
incur for buying seats on commercial flights or for chartering flights. It
expects that the year-to-year growth in the annual savings would be 10%.

The
choice has narrowed down to two planes: the Aero Commander and the Super Eagle.
Both provide the same savings and the same basic service (e.g., the same
passenger and luggage capacity, flight speed, and maximum altitude of
operation).

The
Aero Commander jet sells for $4,500,000. Its normal operating expenses would be
$290,000 the first year and would increase 8% per year thereafter. In addition,
there would be a cost of $350,000 for a major engine overhaul at the end of the
third year. Treat the overhaul cost as an operating expense. The cabin noise
level in the Aero Commander is lower than in the Super Eagle, and its seats are
somewhat more comfortable.

The
Super Eagle jet sells for $3,950,000. Its normal operating expenses would be
$325,000 the first year and would increase 8% per year thereafter. In addition,
there would be major engine overhauls at the end of the second and fourth
years, each of which would cost $300,000. Treat the overhaul costs as operating
expenses.

Dinsmore
uses a WACC or discount rate of 10% and a reinvestment rate of 9% to evaluate
its investments in fixed assets. Tax rates are 38% for regular income and 25%
for capital gains or losses.

The
jet purchased would be paid for and put into service during the first quarter
of Dinsmore’s financial year. It would be depreciated according to the
appropriate MACRS schedule from (i.e., 7-year life with first-quarter
convention).

Dinsmore
expects to sell whichever plane it chooses at the end of the fifth year for 20%
of its purchase price.

1.
What is the NPV, IRR,
and modified internal rate of return associated with each of the two jet
planes? Based on these values, what action do you recommend Dinsmore to take?

2. What
non-financial information should Dinsmore take into consideration before making
its final decision? Why might the information be important in Dinsmore’s
decision? How might this information change the decision in part 1?