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Cincinnati Express is a small regional airline. To open a new route, the airline must buy two commuter airplanes at an estimated cost of $3m each, after tax. Other start-up costs are expected to be $500,000 after-tax. Annual operating costs are expected to be $600,000 per year after-tax. Costs are largely fixed, and do not depend on revenue. As with many new routes into small towns, demand is uncertain until the service has actually been offered. Demand after the first year is expected to be very similar to that in the first year. A discrete probability distribution for revenue is shown in the table below;
Probability
.1
.2
.4
Revenue (after tax)
700,000
900,000
1,200,000
1,500,000
2,000,000
If the route turns out to be unprofitable, the airplanes can be sold for an estimated market value of $2.5m at the end of the first year. The airplanes will last approximately 10 years, after which they will have an estimated salvage value of $250,000. A 10-year horizon is used for decision making.
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