Capital Budgeting Information (17 Marks) Present an itemised breakdown (and the total) for each of the following: Q1. The Cash Flows at the start. Q2. The Cash Flows over the life. Q3. The Cash Flows at the end. Q4. The NPV of the capital budgeting decision and a short explanation of your recommendation. Congratulations, you were hired as a financial analyst for Kangaroo Airlines following your studies at the University of Technology Sydney. Kangaroo Airlines is one of the leading Australian carriers. 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, skills, and ability to get the job done. As a result, the Chief Financial Officer (CFO) Lebron Jordan has asked you to perform a capital budgeting analysis of the new Skyliner planes. The Skyliner planes will be the first planes capable of flying from Sydney to New York non-stop. In order to conduct your analysis, you will need to use the information below that has been provided to you by Rihanna Ronaldo-Grande from the accounting department, and Virgil Salah and Jay Lopez from the sales/marketing departments. The information provided to you is detailed in the numbered paragraphs below (figures are in AUD, unless stated otherwise). 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 Senior Management who will approve/decline investment in the new planes. For Q1, Q2 and Q3, for each cash inflow and outflow report the total across the three Skyliner planes in your Excel spreadsheet. Information gathered from various departments: 1. Just prior to the COVID pandemic (approximately one-and-a-half years ago), Kangaroo Airlines undertook its first non-stop test flight of a Skyliner plane from New York to Sydney. The flight took 18 hours to cover the 16,200 kilometre journey. Typically, this route would take approximately 22 hours including a fuel stop in Los Angeles or San Francisco. The Skyliner plane has a fuel tank of 125,000 litres (each plane will be filled with this much fuel per journey), is more fuel efficient, and has less economy seats than existing planes flying the same route. During the test Skyliner flight, scientists and researchers were aboard to analyze the activity, alertness, food and drink, and sleep patterns of passengers, crew, and pilots. Passengers onboard were very satisfied with the increased comfort of the seats, increased space between seats and in the aisles, with the service from the cabin crew, satisfied with the amount of food and drink provided, and were pleasantly surprised that they only experienced similar levels of jet-lag as experienced during the typical one-stop flight. In a post-flight survey, the average score given by passengers for overall satisfaction of the flight was 4.2 out of 5. The test flight cost Kangaroo Airlines $500,000. All operating expenses are tax deductible in the year the expense is incurred and the company tax rate is 30%. Hint: Assume that all operating cash flows occur at the end of the year, unless specified otherwise. 15. Kangaroo Airlines will immediately purchase eight custom-designed shuttle buses to transport passengers from the airport terminal to the staircases to board the Skyliner planes. The custom-designed shuttle buses will be designed to provide similar services as an airport lounge. Kangaroo Airlines will require four shuttle buses for use at Sydney airport costing an average $1,430,000 AUD each, and require four shuttle buses for use at JFK airport costing $1,100,000 USD each. Rihanna wants to apply a useful life of 15 years for each bus. 16. Each direct flight from Sydney to New York (and vice versa) requires three pilots to be onboard to fly the Skyliner plane. The Skyliner planes have a unique set of flight controls and safety protocols. To operate the Skyliner planes today, 12 pilots must be trained at a cost of $18,000 per pilot. 17. Whilst the Skyliner planes are in operation, Kangaroo Airlines will incur lost sales on its existing routes: Sydney to Los Angeles to New York, and Sydney to San Francisco to New York. The annual lost sales on existing flights will amount to 15% of the actual annual sales earned by the Skyliner planes. 18. Kangaroo Airlines have a total of 297 planes in its fleet, excluding the Skyliner planes. The headquarters of Kangaroo Airlines is located in Mascot, Sydney. One year ago, the operating costs associated with its headquarters is $5 million annually. With the introduction of the Skyliner planes the total annual operating costs associated with its headquarters is $5 million. For management reporting purposes, the headquarter costs are split equally between each plane within the Kangaroo Airlines fleet. It is rumoured that Kangaroo Airlines will move its headquarters to Brisbane. 19. Last year, Kangaroo Airlines pilots, crew, maintenance and airport staff went on strike, this resulted in a 5% increase in pay for all staff members of Kangaroo Airlines. The pay increase started last year. Previously, salary for Kangaroo Airlines staff had been frozen at the same levels for the past 10 years. Future changes to salary are not expected. It is estimated that the total annual salary for staff to operate each Skyliner plane is $2.80 million. 20. Kangaroo Airlines anticipate the re-introduction of a more affordable Concorde airliner in the medium-term future. The Concorde airliners were discontinued in the early 2000's due to significant costs of operating such planes, safety concerns, and low demand. The Skyliner capital budgeting project is expected to last ten years, as Kangaroo Airlines will sell the Skyliner planes ten years from today. According to Ash Barty (a representative from the Australian Tax Office), the effective life of each Skyliner plane is 25 years, and the useful life of each of the associated custom-designed shuttle buses is 20 years. 21. At the conclusion of the Skyliner project, the International Air Transport Association forecasts that the value of each Skyliner plane will have a market value of $140 million, and each custom-designed shuttle bus used in the Skyliner plane project will have a market value of $600,000 AUD. 2. Kangaroo Airlines began exploring the idea for introducing a direct flight from Sydney to New York following the results of a market research report provided by an external company Drake Consulting Group. The report indicates that both business and economy passengers would be interested in a direct long-haul flight, if it saved them even a few hours in travel time, if larger seats with more comfortable padding and an increased reclining ability were provided. The market research report cost Kangaroo Airlines $45,000 three years ago. 3. Two years ago, Kangaroo Airlines paid the two largest plane manufacturers (Airtaxi and Eagle Manufacturers) $1 million each to design a Skyliner plane capable of undertaking the direct flight between Sydney and New York. In addition, for the winning design, Kangaroo Airlines will pay the winning plane manufacturer $80 million per year for exclusive rights to use the planes for the first three years of the Skyliner project. Melon and Lebron decided that Kangaroo Airlines will use Airtaxi to manufacturer the Skyliner planes. Rihanna suggests that the $1 million design fee to Airtaxi and Eagle Manufacturers be recorded in the capital budgeting analysis, split evenly during each year of the project's life. 4. Today, Kangaroo Airlines will purchase three Skyliner planes (each with a unique engine number) for a total cost of $600 million. By purchasing three planes, this ensures that Kangaroo Airlines can have one direct flight leaving New York to Sydney each day, and have one direct flight leaving Sydney to New York each day. Historically when Kangaroo Airlines have purchased new planes they have used a useful life equal to 30 years when reporting depreciation in their internal reports. 5. Kangaroo Airlines is owned by Aussie News Corporation. Aussie News Corporation is the biggest news, television and media company in Australia, and typically applies a required return of 9% for its capital budgeting projects. Ms Ronaldo-Grande suggests that this required return should be applied to the Skyliner project as it will help increase the net present value of the project. The required retum that Kangaroo Airlines applies to projects with a similar risk profile as the Skyliner planes is 12%. 6. Maintenance, safety checks, and cabin cleaning will take place once the Skyliner planes land in Sydney and New York. The total annual maintenance, safety checks, and cabin cleaning costs for Kangaroo Airlines will increase by $6.1 million from $300 million from the introduction of the three Skyliner planes. 7. In order for the immediate operation of the Skyliner planes, Kangaroo Airlines must increase its operating inventory by $2 million per plane, and its total spare parts inventory across the three Skyliner planes by $6 million. The cost of replenishing all inventory is included in the annual maintenance, safety checks, and cabin cleaning cost figure. 8. Due to uncertainty relating to international boarder restrictions and the success of vaccine programs around the world, Kangaroo Airlines will pay for some of the hotel quarantine costs incurred by passengers landing in Sydney during the first two years of operation. In Year 1, it is anticipated that hotel quarantine costs will total $10 million for Kangaroo Airlines, however, only 5% of these costs are related to the Skyliner planes. It is anticipated in Year 2 that total hotel quarantine costs for Kangaroo Airlines will be double that of Year 1, and from this total 7% are attributed to the Skyliner planes. From Year 3 onwards, hotel quarantine is not expected to be required by travellers. 22. All airlines are charged an airport tax for the use of each airport around the world. Due to significant heterogeneity across the world, the International Air Transport Association ruled that all airports can only charge the same fixed annual airport tax of $1 million AUD per plane with unique engine number that lands at the airport (this airport tax does not vary by the number of times that a plane with unique engine number lands at a particular airport). 23. Upon the establishment of an airline company, each airline company must pay a one-time initiation fee of $10 million to the Australian Government, otherwise they cannot operate in Australia. 24. Kangaroo Airlines currently pays $500,000 p.a. to rent office space in North Sydney for its call centre. The annual salary for call centre staff at the North Sydney office totals $900,000. Kangaroo Airlines want to pitch the Skyliner planes as a more premium product, as a result, they will hire additional call centre staff and relocate their call centre to Ryde. The Ryde call centre will have annual salary costs of $1,000,000 and annual rent costs of $600,000. 25. The introduction of the Skyliner planes is expected to increase the annual total insurance costs for Kangaroo Airlines by $3.22 million to $90 million. It is expected that the annual insurance costs incurred by Kangaroo Airlines will increase by 0.5% per year during the next 15 years (assume insurance costs occur at the end of the year). The increased insurance costs are predicted due to the increased payouts faced by insurers relating to COVID-19, bushfires, and flooding in Australia. 26. Kangaroo Airlines obtains their onboard catering externally from Gate Gourmet. Prior to the Skyliner project, total annual catering costs for all existing planes in the Kangaroo Airlines fleet is $900 million. Each Skyliner plane requires $5 million of catering costs per year. For showing customer loyalty Gate Gourmet provide Kangaroo Airlines a bulk buying discount, as a result total annual catering costs for Kangaroo Airlines (including the Skyliner planes) is $914 million. 9. It is forecasted that in Year 3 that any airline company that has planes which depart or land in Australia will have to pay a climate change fee to the Australian Government. Irrespective of the number of times each unique plane departs or arrives in Australia, this climate change fee will total $1 million p.a. per plane with unique engine number. 10. Excluding the Skyliner planes, the total current annual fuel costs for Kangaroo Airlines is $7,000 million. It is estimated that a total of 1000 flights will be undertaken across the three Skyliner planes each year. Today jet fuel costs $1.50 USD per gallon, and 1 USD is equal to 1.30 AUD (where USD is United States dollars and AUD is Australian dollars). Accounting for seasonal patterns and macroeconomic changes, it is expected that the price of jet fuel and the USD/AUD exchange rate will be the same over the next ten years. 11. Due to the COVID pandemic and resulting travel restrictions, if the Skyliner planes were fully booked, total sales for Year 1 are expected to total $280 million. During the second and third years of operation, it is forecasted that total sales from the three Skyliner planes will be $600 million per annum (this is assuming the planes are fully booked). After Year 3, it is forecasted that competitors like Air America and Emiritz Airways will provide similar direct routes between Sydney and New York, as a result, total sales associated with the Skyliner planes will fall by $200 million to $400 million per annum (assuming the planes are fully booked). It is anticipated that on average that the Skyliner planes will be 80% filled during the entire time they are operated. 12. Kangaroo Airlines are going to apply an aggressive marketing campaign to launch the Skyliner planes. This campaign will involve numerous print, digital and various media advertisements including sponsorship of the Australian team at the Olympic games in Tokyo, and celebrity endorsements from Margot Robbie, Chris Hemsworth and Daniel Riccardo. Immediately, marketing costs will total $18 million. For the remainder of the project, marketing costs associated with the Skyliner planes will increase Kangaroo Airlines total marketing costs by $4 million to $120 million per annum. 13. To finance the purchase of the new Skyliner planes, Kangaroo Airlines will borrow 50% of the purchase price over a ten-year period from the Bank of Australia. The principal and interest repayments associated with the debt are equal to $40 million per annum. 14. Due to their shape and size, the new Skyliner planes will not be able to land and park in traditional airport gates. As a result, the Skyliner planes will park at unique gates at both Sydney and John F. Kennedy airports, and each Skyliner plane will require eight airplane staircases so that passengers can enter and exit the plane. Kangaroo Airlines have eight idle airplane staircases which have been written off for tax purposes in both their Sydney and New York warehouses located close to the airports. The sixteen airplane staircases were purchased in the past for $250,000 each, and can be sold today for $50,000 each. It is forecasted that the sixteen staircases will be worthless at the end of the Skyliner capital budgeting project. Virgil suggests that the airplane staircase cash flows are irrelevant in the capital budgeting decision of the new Skyliner planes.