Airvalue Airways is a regional carrier whose strategy is to expand gradually as they can identify routes that offer an attractive return on the investment necessary to support successful coverage of the route. As part of this expansion, the company is planning to buy a new plane in the upcoming fiscal year. The purchasing department has narrowed the choice down to two models. One is the A220 which is manufactured in Europe. The other plane is the G435 which is built in the United States. The two aircraft have similar profiles. However, the locally-built G435 is significantly more expensive to purchase.
The A220 has an expected life of 5 years, will cost $90 million and its use will produce net operating cash inflows of $30 million per year. The G435 has a life of 10 years, will cost $128 million, and its use will produce net operating cash inflows of $25 million per year. Airvalue plans to serve the route for 10 years. When they need to purchase a new A220 at the end of five years, the cost will be $115 million net after allowing for salvage value of the used plane. Net operating cash inflows will remain at $30 million throughout the second five years. At the end of 10 years, salvage value of the G435 and of the second A220 are expected to be about the same at approximately $500,000 each.
As the company’s CFO you are to provide the financial analysis that will be considered by the strategic planning executive committee during evaluation of this expansion alternative. Your plan is to use a capital budgeting approach to the analysis in order to best assure that the decision will result in maximization of wealth for the company’s stockholders. You also want to convert the entire committee to the concept that capital budgeting should be used as the main tool for the financial analysis of capital expenditure alternatives.
The company uses the historical difference in returns between the S&P 500 and the Treasury bond rates of 7% as their estimated market risk premium. The current yield to maturity on a 10-year Treasury bond is 6.2%. Airvalue Airways’ common-stock equity beta is estimated as 1.40.
Airvalue’s capital structure is 58% common stock, 32% preferred stock and 10% long-term debt. An 8.8% after tax cost of debt has been determined and the cost of preferred stock is 12%.