Question

Confused about how to add the 3x as much part into PV of CCATS formula.

QUESTION 3: Airsonics Limited has been asked by Sunny Exploration Limited to provide an air shuttle service to their oil exploration site. Airsonics will have a two year contract with Sunny with the possibility of renewal for another 4 years. Airsonics has the following choices: Buy the helicopter for $2,000,000, or Arrange a 6 year non cancellable lease, for $400,000 per year, paid at the beginning of each year. Assume that the CCA rate for the helicopter is 30%, and CCA will be claimed at the end of each year. The corporate tax rate is 40%. The weighted average cost of capital is 12% and Airsonics can borrow at 8%. If Airsonics purchases the helicopter, before tax operating cost will be $200,000 per year, payable at the beginning of each year. After 6 years helicopter will be worth either $400,000 or $600,000. Probability that it will worth $600,000 is 3 times as much as that it will worth $400,000. There is 30% chance that after two years contract will not be renewed. In that case helicopter will be sold at a short notice for $1,000,000. Assume asset pool will remain open. If Airsonics leases the helicopter, and contract is not renewed after two years, then Airsonics has to pay a penalty of $300,000 to break the lease. Before tax operating cost will be $150,000 per year, payable at the beginning of the year. Should Airsonics lease or purchase the helicopter?

Answer 1

Since there are two options, we will have to take both in consideration. The probability of $600,000 is 3 times as much as $400,000. So, let the probability os 400,000 be a . Then, the chances of $600,000 will be 3a.

There are two possibilities only. The probability of both the instances can only equal to 1.

Hence, a +3a =1. The value of a will come to 0.25. Hence, the probability of $400,000 will be 0.25 whereas probability of $600,000 shall be 0.75.