Question

You were hired by a private local airline company. The company is planning to initiate a few new routes in the south of the United States. As the project manager you have been tasked with conducting a feasibility study, and to make a recommendation to the CEO about whether or not to undertake this project. You commissioned a market research firm to study the demand for your new offering. The market study cost $750,000 and was very promising. You were also in negotiations with local airports about landing fees and terminal access. As a condition for these negotiations the airports demanded a payment of $2,500,000 that can be applied towards your airport and landing fees if the negotiations are successful.

In order to initiate the new services you would need to acquire two additional airplanes for $40,000,000 each. The expected life of the planes is 20 years, and their salvage value is about $5,000,000. Your analysis for the project includes the following estimates:

Sales in the first three years will be $44 million, $67 million and $91 million. Sales are expected to grow at a rate of 3.5% thereafter. The direct costs of operating the aircraft are estimated at 65% of sales, and the landing and airport fees are 5% of sales. The general administrative costs for the company as a whole currently are about $70 million and based on prior experience grow at a rate of 3% a year. The project will require an additional $15 million in administrative costs for the first year. The new lines constitute about 15% of the current business, and the company plans to allocate the administrative costs on a prorated basis.

The new lines would require about $1,000,000 in cash initially, and the amount would grow to $1,500,000 at the end of the year. The cash required would remain at the same fraction of sales thereafter. The project would also require an initial investment in fuel and other supplies of about $3,000,000 that will grow at a 3% rate. Accounts receivable and accounts payable are initially $1 million each but are typically 7% and 8% of sales respectively.

Assume a marginal tax rate of 34% for all tax calculations.

Given that your company is private, you look at competitors to calculate the discount rate. You decide that the main competitors are Delta Airlines, United Airlines, and Southwest Airlines. You believe that your equity cost of capital is equivalent to the average of the three airlines. Your company bonds with a coupon of 6% and 8 years to maturity are trading at $104.83. Your company has a debt-to-assets ratio of 0.25, and you plan on maintaining this leverage ratio for the foreseeable future. You can use the average return on the S&P 500 index over the past 20 years as the expected market return and the current T-bill rate as the risk free rate (Note that rates are reported monthly not annually).

You only plan to operate for 10 years and you estimate that the planes will only be worth $10 million each at that point. But you estimate that you can sell the rights of operating these lines at that time for $15 million, and you expect to liquidate all other assets at book value. What is your recommendation regarding the project? Show all intermediate steps.

Answer 1

Project has positive NPV and should be accepted.