As the newest business analyst for Qantas, you are meeting with the CFO, Sarah, to finalise the current quarter's acquisition proposals for aircraft. Upon sitting down in the meeting room, Sarah starts the conversation... Rather than buying aircraft outright, we are exploring a new offer from our bank for operating leases, where we rent the aircraft instead. So, we save on a capital purchase upfront but the lease clause includes an upfront aircraft insurance policy, that we have to pay as a lump sum premium. The lease payments are a percentage of the net revenue the aircraft generates each quarter, so our net cash flow will be the remaining quarterly net revenue after subtracting the lease payments. This net cash flow will be earned every quarter till the end of the lease maturity, after which we return the aircraft and don't have to bother with disposing of a capital asset. Sarah then hands you a briefing sheet with the following information ... Aircraft Insurance premium Initial Net Revenue/quarter Net Revenue growth/quarter Quarterly Lease payment Lease Maturity (Yr) Airbus A380 $890,000 $320,000 +2.5% 25% 2 Boeing 737 $950,000 $230,000 +5% 35% 2.5 Comac C919 $630,000 $420,000 -3% 30% 1.5 Sarah nods her head... Ok, lets meet up after 2 hours and we can discuss your capital budgeting analysis that needs to include the payback period, discounted payback period, NPV, IRR and PI for all the leases. The cost of capital for Qantas is 12% p.a. so don't forget to adjust this to a quarterly discount rate. There is no cut-off payback period to be applied. Assuming mutually exclusive leases, which lease do you recommend by each of the metrics? Ignore that the projects have different lives and ignore having to use equivalent annual annuties (covered in the next topic). You reply... 1) With no cut-off period, the lease with the shortest payback and discounted payback period is the a) C919 at 2.18 and 2.3 quarters b) A380 at 1.18 and 1.3 quarters c) 737 at 3.18 and 3.3 quarters 2) The lease with the highest positive NPV is a) A380 at $942,712.08 b) 737 at $842,712.0.8 c) C919 at $742,712.08 3) The lease with the highest IRR > RRoR is a) C919 at 38.05% > 3% b) A380 at 28.05% > 3% c) 737 at 48.05% > 3% 4) Finally the least with the highest positive value added per dollar of invest is a) C919 at 1.35 b) A380 at 2.35 c) 737 at 3.35 5) Sarah follows on with an important question... We have a conflict between IRR and NPV decisions. One lease has three metrics supporting it including IRR while the alterantive has only NPV in support. What is your final recommendation of which lease to accept, given that the options are mutually exclusive? Provide your reasoning. a. The A380 is accepted as given a conflict between metrics in mutually exclusive projects, NPV is the deciding indicator as it is free of reinvestment risk: i.e. cash flows are reinvested at the cost of capital, which is conservative and realistic. b. The C919 is accepted as the it has the support of three metrics, which is overwhelming evidence. The A380 is only supported by NPV and has a low PI and IRR. c. The 737 is accepted because I like Boeing and I don't like Airbus nor Comac. d. None of the projects should be accepted as there is no clear cut project that has the support of all capital budgeting metrics. 6) Sarah concludes the meeting by saying... When we present this to the board, they will want to know why there is a conflict in metrics. Calculate the crossover rate between the C919 and A380 and compare it to the discount rate used. You quickly do the analysis and reply... Ah, that explains it, the crossover rate is a) 6.28% / quarter b) 6.28% / year c) 8.26% / quarter d) 8.26% / year . That's why we are getting a conflict because our discount rate is a)lower b)higher the crossover rate.