After the bankruptcy of Skyways Express, SvenskAir has taken over the licence to fly passenger aircraft between Vrnes airport near Trondheim and Arlanda airport near Stockholm. So far it has not been profitable to open the route, but SvenskAir has made a business plan that shows that the route Arlanda-Vrnes could become a very profitable one in the near future. However, developments in the airline industry could also make it very unprofitable. In financial terms this means that the present value of the cash flows from operating the route can increase by 47.5% over each of the next two years, but they can also decrease by 32.2%. Today, the present value of these cash flows is estimated at 45 million. However, it requires an investment of 46 million to start the route, so the project has a negative NPV and should not be accepted. The decision cannot be deferred either, because the licence expires at the end of the year. A junior employee, who took the course Finance for Science and Technology students, suggested negotiating a sell-back option for the equipment with the supplier. There is a well functioning second hand market for the type of regional airliner involved. After some discussion the supplier is willing to buy back the equipment for 35 million after one year and for 30 million after two years. However, including the option will increase the purchasing price of the equipment by 1.5 million to 47.5 million. a) Assuming a risk free interest rate of 7% per year and using a three-moment, two- period binomial model, calculate the value for SvenskAir of the option to sell back the equipment and the effect this has on the decision to open the route. After the bankruptcy of Skyways Express, SvenskAir has taken over the licence to fly passenger aircraft between Vrnes airport near Trondheim and Arlanda airport near Stockholm. So far it has not been profitable to open the route, but SvenskAir has made a business plan that shows that the route Arlanda-Vrnes could become a very profitable one in the near future. However, developments in the airline industry could also make it very unprofitable. In financial terms this means that the present value of the cash flows from operating the route can increase by 47.5% over each of the next two years, but they can also decrease by 32.2%. Today, the present value of these cash flows is estimated at 45 million. However, it requires an investment of 46 million to start the route, so the project has a negative NPV and should not be accepted. The decision cannot be deferred either, because the licence expires at the end of the year. A junior employee, who took the course Finance for Science and Technology students, suggested negotiating a sell-back option for the equipment with the supplier. There is a well functioning second hand market for the type of regional airliner involved. After some discussion the supplier is willing to buy back the equipment for 35 million after one year and for 30 million after two years. However, including the option will increase the purchasing price of the equipment by 1.5 million to 47.5 million. a) Assuming a risk free interest rate of 7% per year and using a three-moment, two- period binomial model, calculate the value for SvenskAir of the option to sell back the equipment and the effect this has on the decision to open the route
