Situation 1: no tax shield available to the company
In the given situation, the airline company needs to evaluate the cash flows from both the alternatives. The alternative with least cash outflow should be opted for. We have calculated the cash flows from both the alternatives. Also, we have calculated the cash flows if any tax shield were available to the company.
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Situation 1: no tax shield available to the company:
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Cash flows from old loader (ignoring tax shield)
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Annual Variable Operating Expenses
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80,000
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|
|
Less: Salvage for the loader
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5,000
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Net Cash Outflows
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75,000
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|
|
|
|
|
|
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Cash flows from new loader (ignoring tax shield)
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Cost of the New Loader
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20,000
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Annual Variable Operating Expenses
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50,000
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Net Cash Outflows
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70,000
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From the above calculations we can see that cash outflows from the new loader are less than that of the old loader. Therefore, keeping the above costs into consideration, we can conclude that the company should replace the old loader with the new one; this will help the company save $5000.
Situation 2: Tax Shield available to the company:
We have assumed that the applicable tax rate for the company is 30%.
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Cash flows from old loader (net of tax shield)
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Annual Variable Operating Expenses
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80,000
|
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Less: Salvage for the loader
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5,000
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Cash Outflows
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75,000
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Less: Tax shield on above cash flows (75000*0.30)
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22,500
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Less: Depreciation tax shield (25000*0.30)
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7,500
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Net Cash Outflows
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45,000
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|
|
|
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Cash flows from new loader (net of tax shield)
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Cost of the New Loader
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20,000
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Annual Variable Operating Expenses
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50,000
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Net Cash Outflows
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70,000
|
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Less: Tax shield on above cash flows (50000*0.30)
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15,000
|
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Less: Depreciation tax shield (20000*0.30)
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6,000
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Net Cash Outflows
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49,000
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From the above calculations we can see that the cash outflows from the old loader are less than that of the new one. This is so because, the company will not get any tax benefits on the amount expended on the capital asset, which is the new loader. Therefore, based on the above calculations, the old loader should not be replaced with the new.
Let us first compute the profits under both the circumstances. The table below shows the profit earned by the company under both the circumstances.
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Calculation of Profits
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Particulars
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Non-Stop Flight
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New Flight Route
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Difference
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Passenger revenue
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2,40,000
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2,51,000
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11,000
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Cargo revenue
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80,000
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80,000
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–
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Flight crew cost
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-2,000
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-3,400
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-1,400
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Fuel
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-21,000
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-26,000
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-5,000
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Meals and Services
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-4,000
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-4,900
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-900
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Aircraft maintenance
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-1,000
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-1,000
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–
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Additional Landing Costs
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–
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-5,000
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-5,000
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Profit
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2,92,000
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2,90,700
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-1,300
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From the above table we can see that the alternative flight route would help the company earn extra revenue of $11,000, but it would also result in extra expenses of $12,300. This results in net cash outflow of $1,300. Therefore, the company should not bring any changes in its current route.
Apart from the financial benefits, the company should also consider non-financial factors before taking a final decision. The company should check for the feasibility and practicality of the decision, before making a conclusion. Sometimes new options are beneficial financially, but implementation of these options is very complicated. The company should also check for servicing arrangements before taking a final call. They should conduct proper research and check for future viability of the option. The quick availability of resources is present or not should also be considered; else the company would lose revenue. A thorough SWOT analysis of the new option should be conducted which will help the management in decision making process. The laws have become strict and have laid huge penalties on companies incurring environmental costs. The management should also take into consideration the environmental costs to be incurred due to the new option, before taking a final decision. Therefore, all the points mentioned above should also be considered along with the financial results.
In case the airline company has spare capacity it can accept the special tourist charter flight, if it helps the company generate higher profits. Below is the table which depicts the profits of the company if the charter flight is accepted:
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Profit Statement (in case of Spare Capacity)
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Particulars
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Amount
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Passenger Revenue
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2,50,000
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Charter income
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1,60,000
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Cargo Revenue
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–
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Total revenue(A)
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4,10,000
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Variable expenses
|
85,000
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Fixed cost
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80,000
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Total expenses(B)
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1,65,000
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Total profit(A-B)
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2,45,000
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The profits of the company without accepting the special charter flight is $110000 and with the special charter flight is $245000. Therefore, we see that the company earns higher profits if it accepts the proposal of special charter flight in case of spare capacity.
Other factors which should be considered before the final decision include environmental costs, availability of resources, future viability of the new option, etc. the company should have an in-depth research of the new option before taking any final call.
In case the company has no spare capacity, it can either continue with its existing business or it can accept the special charter proposal. We need to evaluate the profits for the company under both the situations in order to take the decision.
Profits in case of existing flight route:
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Profit Statement (in case of no Spare Capacity)
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Particulars
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Amount
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Passenger Revenue
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2,50,000
|
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Cargo Revenue
|
30,000
|
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Total revenue(A)
|
2,80,000
|
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Variable expenses
|
90,000
|
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Fixed cost
|
80,000
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Total expenses(B)
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1,70,000
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Total profit(A-B)
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1,10,000
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If the special charter flight is opted for then it would help the company earn a straight away profit of $160000. Therefore, since the profits from special charter flight are higher than that of existing flight route, the company should opt for special charter flight in case of no spare capacity.
In the above conclusion we have assumed that in case of special charter flights the expenses are to be borne by the Japanese tourist company.
Other factors which should be considered before the final decision include environmental costs, availability of resources, future viability of the new option, etc. the company should have an in-depth research of the new option before taking any final call.
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