Capital Budgeting Information (17 Marks)

ANSWER the following:

Q1. The cash flows at the start.

Congratulations, you were hired as a financial analyst for Royal Oceania Cruises following your studies at the University of Technology Sydney. Royal Oceania Cruises is the leading luxury cruise provider in the Australasian region. You fought off tough competition for the job, the recruitment team selected you for your personable character, analytical mind, ability to solve problems, and experience of working well in teams. You have really impressed senior management with your finance knowledge and ability to get the job done. As a result, the Chief Executive Officer (CEO) Taylor Swifty and Chief Financial Officer (CFO) Hugh Jackman have asked you to perform a capital budgeting analysis of a new cruise ship("Pacific Dream").In order to conduct your analysis you will need to collect information from different departments of the firm. The information that you have collected is detailed in the numbered paragraphs below. It is your job as a financial analyst to decipher which information is relevant to the capital budgeting analysis. Upon completion, you will present your analysis to the Board of Directors who will approve/decline investment in a new cruise ship.

Information gathered from various departments:

1. Six months ago Royal Oceania Cruises paid $30,000 to Wallaby Consultants for market research investigating thedemand for a new ship ("Pacific Dream"). The report stipulates thatthere is strong demand from tourists, individuals aged 30-60, and from individuals who earn an income of $120,000+ per annum.

2. Two months ago, Royal Oceania Cruises invited its wealthiest and frequent cruise customersto an event held at "The Star" casino.The event had a total cost of $5,500 to cover payments for the event space, food and drink and service staff. The purpose of the event was to learn what would be desirable in thenew "Pacific Dream" cruise ship. Roger Federer (from theAccounting department) suggests that the $5,500 event costs should be included as anopportunity cost incurred in year 0 of the "Pacific Dream" investment decision.

3."Sea Princess" and "Ovation of the Seas" are the twoother existing cruise ships in the Royal Oceania cruise fleet, both of these cruise ships have been depreciated over a 15-year life. The"Pacific Dream" will be purchased todayfor $32 million and will be the largest and most luxurious cruise ship operating in the Oceania region.The "Pacific Dream" will measure 348metres in length, be able to reach a maximum speed of 30 knots and has a maximum passenger capacity of 2,000 customers. Due to the advanced navigational system, novel skydiving opportunities, and mini submarines allowing customers to uniquely observe sea life andcreatures, Roger suggests that "Pacific Dream" should be depreciated over a25-year life.

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4.Due to the significant size of the "Pacific Dream", Sydney Ports requires that the "Pacific Dream" beimmediately fitted with a special thruster to manoeuvre within tight spaces. The current market value of a special thruster is $5 million, Roger expects the special thruster to have a useful life of 20 years.

5. The special thruster generates an unpleasant sound when in operation. Royal Oceania will immediately install a noise cancelling device to reduce the effects of the unpleasant sound generated by the special thruster. According to the Royal Oceania Cruises accounting books, an idle noise cancelling device (which has been written off for tax purposes) is currently storedin their North Sydney premises and is compatible with the "Pacific Dream" cruise ship. TheGlobal Maritime Agency website shows that the current market value for the noise cancelling device is $750,000 and forecasts indicate that the noise cancelling device will be worthless 10 years from today. Roger informs you that the noise cancelling device was previously purchased for $2 million.

6. All cruise ships operating in Australian/international waters must purchase a maritime licence. The license must be purchased today and costs $555,000 and lasts for a three-year period. If a cruise ship does not have a license it cannot operate in Australian/international waters. The license can be claimed as an operating expense in the year in which the license was purchased. All operating expenses are tax deductible in the year the expense is incurred and the tax rate is 30% (hint: if an operating expense is incurred in Year 0, then you can record the tax deduction in year 0). The license cost has remained the same since it was introduced in 2005, and the cost is expected to remain the same in the future.

7. To heavily promote the"Pacific Dream", Royal Oceania Cruises will spend $2.10 million p.a. during the first two years of operation. This campaign will involve sponsorship of the Wallabies during the 2019 World Cup in Japan and subsequently of the Socceroos in the lead up to the 2022 World Cup. Following the end of Year 2, advertising for the "Pacific Dream"will total $750,000 annually.

8. Hugh is slightly concerned by the large marketing costs associated with the"Pacific Dream"investment, so in agreement with Taylor they decide to reduce the total annual advertising expenses associated with the"Sea Princess"and"Ovation of the Seas"from $975,000 p.a. to $810,000 p.a. during theentire life of the "Pacific Dream" project.

9. During a lunchtime briefing the sales team provide you with the following sales informationabout the "Pacific Dream",the sales information provided below accounts for seasonal patterns:

• Average sales price per customer = $1,000 per cruise journey.
• 25 "Pacific Dream" cruises run every year.
• Average number of customers = 1,500 per cruise journey.
• 10.The introduction of the "Pacific Dream" is expected to cannibalise the sales of the "Sea Princess" and "Ovation of the Seas" duringthe entire"Pacific Dream" investment. In total, thesales team forecast that total sales across the "Sea Princess" and "Ovation of the Seas" willdecline by $5 million annually.
• 11.The "Pacific Dream" is expected to increaseRoyal Oceania Cruises total annual fuel expenses by $2.33 million to $4 million. Based on forecasts of future fuel prices and depletingfuel resources, annual fuel expenses for the "Pacific Dream" will increase by 2% every

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following year. The current salary of the 200 crew members required to operate the"Pacific Dream"is expected to total $13,500,000 per annum. However, following the end of year 5 itis forecast that each crew member's annual salary is expected toincrease by $5,000. Further changes in salary are not expected in subsequent years.

12.Due to the introduction of the "Pacific Dream", Royal Oceania Cruises fixed costs(excluding headquarter costs) will increase by $1.75 million to $3.90 million per year. Royal Oceania Cruises headquarters is based in Tower One in Barangaroo. Annual headquarter costs total $3.66 million and such costs are not expected to increase in the foreseeable future. Taylor wants to allocate an equal share of the annual total headquarter costs for Royal Oceania Cruisesacross the "Pacific Dream", "Sea Princess" and "Ovation of the Seas".

13.Without "Pacific Dream"Royal Oceania Cruises require 90 tonnes of food and drink per year where each kilogram costs $28/kg for all cruise ships.The introduction of the "Pacific Dream" will result in bulk buying discounts for Royal Oceania Cruises. With"Pacific Dream"each kilogram of food and drink costs $25/kg for all cruise ships, this brings the total food and drink for Royal Oceania Cruises to 170 tonnes per year, meaning 80 tonnes of food and drinkis required annually for "Pacific Dream".

14. All of the cruise ships in the Royal Oceania fleet dock at the Overseas Passenger Terminalin Circular Quay. "Pacific Dream" will also dock at Circular Quay and will increase the Royal Oceania Cruises total annual port charges from $2.30 million to $2.87 million. When cruise ships dock in Circular Quay they obstruct views of the Opera House and Harbour Bridge, which results in reduced sales for surrounding restaurants (e.g., Aria, Quay, Bennelong). As a result, Royal Oceania Cruises pays these restaurants $40,000 p.a. to account for the loss in sales, this figure is expected to increase by $20,000 per annumwith the introduction of "Pacific Dream".

15.The "Pacific Dream" cruise shipwill mean that the Royal Oceania Cruises call centre will be relocated from North Sydney to a larger facility in Heathcote. The rent expense for the North Sydney centre was $150,000 per annum and the rent expense for the Heathcote centre is $87,000 per annum. The larger call centre is required to fit additional staff members which will increase annual call centre salary expenses by $50,000 to $100,000.

16. During a meeting involving Hugh, Taylor, and the accounting and sales team, it is agreed that the plan is to sell "Pacific Dream" in 10 years' time. To maximise the selling price of the "Pacific Dream" in ten years' time, a regular three-year refurbishment is required, the first refurbishment occurs at the end of year 3 and costs $1.66 million, the second refurbishment costs $2.88 million and the third refurbishment costs $1.96 million. The refurbishments take place during breaks between cruise journeys, and as a result there is no impact upon the operating revenues and other expenses associated with the operation of the"Pacific Dream".The refurbishments keep the cruise ship equipped with the latest restaurants, shops and entertainment. The refurbishment costs can be claimed as a tax deduction.

17.In addition to the major refurbishment costs, the "Pacific Dream" will require annual minormaintenance expenses of $0.96million. If Royal Oceania Cruises proceed with the "Pacific Dream"project the spare parts inventory must be increased by $1.33 million from existing levels and purchased immediately. The annual maintenance of $0.96 million includes the costof replenishing the inventory required to operate the "Pacific Dream".Royal Oceania Cruises will alsohave to purchase additional insurance for the "Pacific Dream" at $2.56 million per annum (hint: assume that cash flows relating to insurance occur at the end of the year).

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18. After a conference call with your contact (Mick Jagger) at the Global Maritime Agency, you learn that if regular three-year majorrefurbishments are made to the "Pacific Dream" then in 10 years' time the "Pacific Dream" will have an estimated market value of $22.90 million.Otherwise, the value of the "Pacific Dream" in 10 years' time will be $15 million. In either case, the special thruster will have an estimated market value of $1.11million in 10 years'time.

19. The Australian Tax Office (ATO) has recently released updates to its tax rulings. Undertaxation ruling 2000/18 "Passenger ships", the effective life of cruise ships like the "Pacific Dream" qualify for an effective life of30 years. According to the ATO, the special thruster has an effective life of 6 years and the noise cancelling device has a depreciation rate of 20% per year.

20.In order to pay for the "Pacific Dream", Royal Oceania cruises will pay $4 million in cash and the rest using debt which will be obtained from the Commonwealth Bank. Roger emails you an amortisation schedule which shows you that the principal and interest payments on the debt are $3.75 million annually, the schedule also shows that the debt will be fully repaid bythe end of the project's life.In consultation with Wallaby Consultants, advisors at the Commonwealth Bank, Hugh and Taylor, the required return for "Pacific Dream" is12.5%.