Assignment One

MakanzeAir Ltd is a new company that intends to provide executive jets on hire for use by the CEOs and other executives of its client firms. The company is trying to choose between the following two alternative options.

Option 1: Acquire second - hand craft. Acquire second - hand craft with a remaining useful life (for the company's purposes) of about 7 years, and replace with similar assets at the end of the useful life. The appropriate second-hand aircraft can be obtained at a price of $3.5 million each but, due to their age and lower fuel efficiency, about $2 million would need to be spent on the annual operating and maintenance costs as such an aircraft. Under the relative alternative Depreciation system, MakanzeAir Limited will be entitled to claim tax depreciation on the purchase cost on straight line basis over the 7 -years period, starting from the first year after purchase. The resdue value of such aircraft on the second-hand market when they are replaced after 7 years would be approximately 30 percent of the price that MakanzeAir limited paid for them.

Option 2: Acquire a new aircraft: Acquire new aircraft with a useful life (the company's purposes) of 25year, and replace with similar assets at the end of the useful life. The appropriate new aircraft can be obtained at a price of $12.5 million. Althouh this is more 31/2 times the cost of the comparable second-hand aircraft, advances in design and fuel-efficiency of newer aircraft would result in the annual operating and maintenance costs being about 50% the level estimated for the second-hand aircraft. Under the relative tax legislation, MakanzeAir Ltd will be entitled to claim bonus depreciation of 50% of the purchase cost of the new aircraft in the first year after purchase. The rest of the value would be depreciated on straight-line basis over the life of the asset, starting from the first year after purchase. It is estimated that the residue value of new aircraft on the second-hand market when they are replaced 25years would be approximately 20 percent of the price that MakanzeAir paid for the them. Revenues will be the same under either of the two strategies. All the above figures are before tax, and at current prices. The company pays corporation tax at the rate of 34%, in the year in which the tax liability is incurred. Tax would have to be paid on the resale value realized in respect of any equipment that has been fully depreciated for tax purposes. Although the current inflation rate of 1.5% per annum is expected to continue for the foreseeable future, the cost and benefits to be used for evaluating this decision are not proposed to be inlfated as it would complicate the appraisal.

MakanzeAir Limited will be usung the following three types of finance, in the ratio of 0.5: 0.2:1

. 6.5% secured borrowings

. 7% mezzanine finance

. Ordinary share capital. The mezzanine finance will carry equity kickers and non-equity kickers, the details of which are still under negotiations. the providers of the mezzanine finance would have a second floating charge over the company's assets. Other information:

. the industry average ratio of debt to equity is 0.5:1

. the industry average beta is 1.09

. the rate of return on the market is currently estimated at 8% annual effective rate.

. the yield on short-dated treasury bills is currently around 0.5%.

REQUIRED

(a) Calculate the weighted average cost of capital of MakanzeAir.

(b) Explain the potential problem in evaluating a project without increasing the cash flows at the rate of inflation, and calculate the discount rate that would be appropriate for dealing with such un-inflated cash flows.

(c) Based on the data provided:

i). Schedule the relevant real after-tax flows of each of the the two alternatives.

ii). Asses appropriately and recommend which of the two alternative strategies MakanzeAir should choose.