Capital Budgeting Question

You are an analyst working in the finance department of Branson Ltd. Branson is a public listed.

tour company that is based in Melbourne. One of its main operating businesses is to provide

tourists with hot-air balloon flights over the city. As the current balloons are due to be retired,

Branson must decide whether to replace them with a large or small model. New balloons have

an expected life of 8 years, after which salvage values are $70,000 for the large balloons and

$45,000 for the small balloons. Market research has estimated that there is a 60% probability

that demand will be high throughout the useful life of the balloons, and a 40% probability that

demand will be low throughout the useful life of the balloons.

The large model is expected to cost $800,000, with an extra installation and shipping costs

of $50,000. The small model is expected to cost $400,000, with an additional installation and

shipping costs of $45,000. The company accountings policy is to depreciate using the reducing

balance approach of 20% per annum. There is also an initial increase in net working capital

of $60,000 for the large model, and $30,000 for the small model. The net working capital is

recoverable at the end of their useful life.

In the event of high demand, the company expects a yearly operating revenue of $1,000,000

for the large model, and a yearly operating revenue of $450,000 for the small model. If the

demand is low, yearly operating revenue is forecasted to be $400,000 for both the large model

and the small model. Annual variable costs associated with operating these balloons are expected

to be 60% of the operating revenue for the large model and 55% of the operating revenue for the

small model. Fixed operating costs associated with operating the large balloons are $100,000

per year, and that for small balloons are $65,000.

You have recently evaluated the capital structure of the company and believes that it is

operating at the optimal level of 60% debt and 40% equity. The weighted average cost of

capital (WACC) from this capital structure is 12.5%. You would also like to understand how

sensitive your capital budgeting decisions are due to changes in WACC. As such, in addition to

determining which model to invest, you want to investigate the effects of WACC on NPV and

the cross-over rates of the large and small models when demand is high, low and the overall

outcome.

Required

You are to prepare (1) the various cash flows based on the different scenarios and (2) the sensitivity analysis using different WACC and the calculation. of cross-over rates. Using Excel as your main analysis tool, evaluate whether the company should proceed with the purchase of large or small balloons, taking into consideration of the various scenarios.