More Description and Details

Upon the assumptions and estimations James Baron made, he is able to have a NPV value of each option to decide which option to undertake. It is a good way to use NPV rule when the projects are mutually exclusive as it gives the direct profitability of each project by magnitude. NPV rule is also consistent with the capital budgeting goal of shareholder wealth maximization. He takes the consideration of the uncertainty of the introduction of PJ-2 and PJ-3 and decides to use a higher cost of capital. By doing this, risk is adjusted to certain degree. He does take into account the estimation of the cost associate with the project by predicted growth rate. He suggests a Discount Cash Flow model to analysis the replacement decision which is easy to understand. In such ways, he is able to get a clear conclusion of which option to undertake.

However, he fails to consider some qualitative factor which will have major influence into his estimation of accounting data.

Firstly, he fails to consider the supply and demand of the airline market. He simply assumes the popularity of the Los Angeles-New York route stays unchanged and the taste and royalty of customers stay constant during the project life. This is a poor assumption especially in a highly competitive market by a long time horizon. The question here is how confidence is his estimation of the passenger load factor. Will it stay the same during the competition? Maybe some analysis like price elasticity of demand can be done to adjust the changing demand. By measuring how a change in supply and demand changes the price and quantity, James is able to get a more realistic data in estimation. Or something like trend analysis can be done to make a better estimation. But obviously, these types of analysis are more complicated and timing consuming. In a word, supply and demand is a very important factor in doing forecasting and need to be adjusted by whatever analysis. Failure in considering the supply and demand will not give a persuadable decision in professional field.

Secondly, he adjusts the risk of introduction of PJ-2 and PJ-3 by a large cost of capital. This may help to eliminate the risk to some degree but once the failure occurred, it will be a completely wordless analysis. Thus, some benchmarks maybe done to help with this extreme situation. For example, some more options can be made to compare with those three options. Say option D, the PJ-2 and PJ-3 will be introduced one year later then planned. An estimated cash flow table can be done by considering this option and hence a NPV value is obtained. This option can be used as a benchmark and analysis can be done to illustrate between the options. Some more similar options can be obtained for this purpose and thus generate a risk premium of the introduction of PJ-2 and PJ-3. Also, a benchmark of profit margin is good to introduce. The margin between all of the options and continues using PJ-1 for the next 15 years will give the firm a clear figure by how much profit the replacement will bring.

Thirdly, he ignores the opportunity cost of not selling all of the planes. He assumes every plane will be replaced when the new planes are bought. In this case, he does not take account into the opportunity cost of, say, replacing only half of the planes. If only half of planes are replaced, what will be the NPV value? He fails to consider this factor which is very important in estimation of cash flow. To maximize the NPV, how many planes need to be replaced? Some techniques like Solver and computer programming are useful when considering this problem. This will give a clear result of which is the best to do to maximize the NPV. Again, those techniques may be complicated and time consuming.

Last but not the least, he assumes straight line depreciation. This is a simple way to consider the depreciation of the equipment but not the appropriate one. In real world, depreciation is not as simply as this especially when there has inflation and tax problem. Some methods like accelerated cost recovery system and modified accelerated cost recovery system maybe introduced when depreciate the equipment.

Overall, James analysis the replacement decision in a simple and understandable but not very promising way. He fails to consider some important factors influencing the decision making process. An investment decision in such a long time scale and large capital requirement is tough to make. Risk analysis and sensitivity analysis have to be included in the consideration. Estimation of cost of capital is crucial in evaluation of the project.

Upon

...