Financial Analysis for High Flyer Airlines Ltd Expansion

You must do Questions 1 – 5a and 10 on a spreadsheet, using appropriate formulae.Hand in as an appendix, a copy of the formulae used in Q1 -5a and 10.

Q:High Flyer Airlines Ltd (HFA) is a rapidly growing airline company serving provincial New Zealand. Its Balance Sheet as at 31 December 2018 is as follows:

The issued capital comprises 150,000 Preference shares (7.5%) and 4,000,000 Ordinary shares.  There are no Retained Earnings at 31 December 2018.

-HFA needs to raise funds for a proposed expansion of services.  The company wishes to maintain the current proportions of long-term debt: equity.  Funds can be raised as follows:

-It can sell five-year, $1,000-face-value bonds with an 10.6% annual coupon interest rate for $1,000.  The cost of issuing these is $58 per bond.-

-8% preference shares with a face-value of $10 can be sold for $9.72, but 20c per share will be retained by the brokers as their commission.  The preference shares will be preferential as to both dividends and return of capital in the event of the company winding up.

-HFA’s ordinary shares currently sell for $2.00 per share.  New ordinary shares can be sold for $1.80 per share, but it will cost 30c per share in flotation and commission costs.

-HFA expects to pay a dividend of 30c per share next year (2019).  Dividend growth of 3% per annum is expected in the future.

 -HFA is considering buying another plane costing $3,800,000 and expanding its flight schedule by 25 flights per week from 1^st January 2019.  The plane would be purchased on 1^st January 2019.  Each flight can carry a maximum of 40 passengers at a standard fare of $90 per flight.  Market research indicates that the flights are expected to be 85% full.

The new plane would be depreciated at 20% per annum on a straight-line prime cost basis and is expected to sell for $250,000 cash at the end of five years.Market development costing $250,000 was carried out in 2018 and has been capitalised in the 2018 accounts.  If the proposed expansion goes ahead, these costs will be amortised on a straight-line basis over five years.  If the expansion does not go ahead, these costs will be written off immediately.  Market research costs are tax deductible in the year they are amortised.

Variable costs are estimated to be $950 per flight in the first year.Fixed costs (excluding depreciation) are expected to total $980,000 in 2019.In order to commence the expansion, the following changes in current asset and current liability accounts are expected in 2019:

Question:

The following changes are expected over the five-year period:

-Fares are expected to increase by 2.5% each year.

-Direct labour costs are expected to increase by 3% per annum.

-Variable costs are expected to increase by 2.5% in both 2020 and 2021; by 4% in 2022 and by 2% in 2023.

-Fixed costs (excluding depreciation) are expected to remain stable for the first three years, then increase to $1,070,000 for both of the last two years.

-In November 2018 HFA purchased a 2^nd-hand plane in anticipation of the expansion.  This plane cost $700,000 and another $50,000 was spent on refurbishing it.  However, after the market research was completed in December 2018, HFA determined this plane would not meet its expansion requirements.  A buyer has offered $600,000 for this plane with settlement date 1 January 2019.  HFA did not depreciate this plane in 2018.

-HFA has arranged an overdraft limit of $250,000.

-HFA Ltd’s financial year is 1 January to 31 December.The tax rate is 28%.The company undertakes projects with a payback period of less than 2.5 years, provided the NPV is positive.

1. Calculate the weighted average cost of capital. 

2. a. Calculate: the initial cost of the expansion, and the terminal cash flow.       

3. Identify the sunk cost and advise how it should be treated. Calculate the break-even number of passengers for the new plane in 2019.

4. Assuming the expansion commences in 2019, prepare ONEstatementfor the five-year period showing the annual budgeted

5. Income Statement, and

6. Discounted Cash Flow Statement, 17 marks

7. Calculate the:

8. Payback period

9. NPV

10. IRR

11. profitability index

12. discounted payback period

13. Because HFA is in such a highly competitive industry with new fare offerings entering the market all the time, one manager doesn’t think sufficient attention has been paid to risk.  He provides you with the following certainty equivalents for the cash flows from the proposed expansion:

1. If this manager has the final “say”, would HFA proceed with the expansion given the additional information?  Show workings and clearly state any assumptions made where applicable in your calculations. 

2. Explain TWO other techniques that could be used to evaluate risk.

3. Identify and briefly explain in your own words the various issues that could increase the risk of not achieving the results you calculated in part 3 above.  

4. Explain why the CAPM is not really valid for assessing the risk of this project for HFA.  (You must provide at least 3 logical reasons for lack of validity).    

5. Write a brief report, stating with reasons and with reference to your answers above whether HFA should undertake the expansion.    

6. Explain in detailhow and why HFA’s working capital would change as a result of undertaking the expansion. 

7. Given that HFA wishes to maintain its current proportions of long-term debt:equity to finance the expansion, calculate:

8. the maximum debt that can be borrowed (eg. mortgage, bonds/ debentures, convertible notes)

9. the number of preference shares to be issued and the proceeds receivable

10. the number of ordinary shares to be issued and the proceeds receivable 5 marks

11. HFA has not decided how it will finance the expansion if it goes ahead.Explain TWO KEY advantages and ONE KEY disadvantages each of the following methods of financing have over each other:

-A new issue of ordinary shares

-A new issue of debentures

-A finance lease.  

12. If HFA did not wish to maintain its current debt:equity ratio, it could borrow $3,300,000 to buy the plane or it could lease it.

1. Determine with reasons whether HFA should buy or lease the plane.  Show all your workings clearly. 

2. What non-financial factors would HFA also consider when making the decision on whether to lease or buy the new plane.  Give reasons for your answer.