Question

Capital Budgeting Apache Airlines is looking to buy some gates at a West Coast airport. The key financial variables are below. Note that the gates revert back to the airport at the end of year 10. Purchase price - $25M Gate renovation (fit-out costs) - $11M (year 2 and in year 6) Yearly revenue - $12M Revenue inflator - 2.8% Operating costs - 40% of revenue Discount rate - 10% Tax rate - 21% What are the NPV and IRR of the gates, should Apache invest in them?

Answer 1

Purchase price	$25 M
Fit-out costs	$11 M
Yearly Revenue	$12 M
Revenue Inflator	2.8%
Operating costs (% of revenue)	40%
Discount Rate	10%
Tax Rate	21%

Calculation of cash flows :

	0	1	2	3	4	5	6	7	8	9	10
Investments	$25M		$11M				$11M
Revenues (inflated at 2.8% from year 2 onwards)		$12M	$12.36	$12.68	$13.04	$13.40	$13.78	$14.16	$14.56	$14.96	$15.38
Expenses (40%)		$4.8	$4.94	$5.07	$5.22	$5.36	$5.51	$5.66	$5.82	$5.98	$6.15
Income before taxes		$7.2	$7.42	$7.61	$7.82	8.04	$8.27	$8.50	$8.74	$8.98	$9.23
Tax @ 21%		$1.51	$1.56	$1.60	$1.64	$1.69	$1.74	$1.78	$1.83	$1.88	$1.94
Net Income after Tax		$5.69	$5.86	$6.01	$6.18	$6.35	$6.53	$6.72	$6.91	$7.10	$7.29
PV of inflows @10%		$5.17	$4.84	$4.51	$4.22	$3.94	$3.69	$3.45	$3.22	$3.01	$2.81
PV of outflows at 10%	$25		$9.09				$6.21

PV of outflows at 10% = $25 + $9.09 + $6.21 = $40.3M

PV of inflows at 10% = $5.17 + $4.84 + $4.51 + $4.22 + $3.94 + $3.69 + $3.45 + $3.22 + $3.01 + $2.81 = $36.86M

NPV = PV of inflows - PV of outflows = $36.86M - $40.3M = -$1.44M

IRR calculated using financial calculator :

CF0 = -25

C01 = 5.69

C02 = -11 + 5.86 = -5.14

C03 = 6.01

C04 = 6.18

C05 = 6.35

C06 = -11 + 6.53 = -4.47

C07 = 6.72

C08 = 6.91

C09 = 7.1

C10 = 7.29

Compute - IRR

We get, IRR = 8.90%

Based on NPV and IRR, Apache should not invest in them because NPV is -$1.44M and IRR is 8.90% which is less than cost of capital i.e. 10%.