Question 2 (30 marks) Read the following scenario and answer the questions that follow:

InstaJets Ltd is a new company that intends to provide private jets on hire for use by celebrities and influencers across Africa. The company is trying to choose between the following two options: Option 1 Acquire used aircraft with a remaining useful life (for the companys purposes) of about ten years, and replace with similar assets at the end of the useful life. Used aircraft can be obtained at a price of about R68.5 million each, but due to their age and lower fuel efficiency, about R30 million would need to be spent on the annual operating and maintenance costs of such aircraft. InstaJets Ltd will be entitled to claim tax depreciation on the purchasing cost on a straight-line basis over the ten-year period. It is estimated that the aircrafts residual value at the end of its useful life will be approximately 25% of its cost. Option 2 Acquire new aircraft with a useful life (for the companys purposes) of 25 years, and replace with similar assets at the end of the useful life. New aircraft can be obtained at a price of R187.5 million. Annual operating and maintenance costs of newer aircraft will be about half the costs estimated for used aircraft, due to advances in design and the fuel-efficiency of newer aircraft.

Under the relevant tax legislation, InstaJets Ltd will be allowed to write off 40% of the cost of the aircraft as depreciation in the first year. The remaining cost of the aircraft will be written off on a straight-line basis over the remaining life of the aircraft, starting from the second year. It is estimated that the new aircraft will be sold for approximately 20% of its cost at the end of its useful life. Revenues would be the same under the two options. All the above mentioned figures are before tax and are stated at current prices. The company pays corporate tax at the rate of 28%, in the year in which the tax liability is incurred. Although the current inflation rate of 5% per annum is expected to continue for the foreseeable future, the cost and benefit figures to be used for evaluating this decision are not proposed to be inflated, as that would complicate the appraisal. InstaJets Ltds capital structure consists of 45% debt and 55% equity. The debt consists of a long-term loan from Capital One Bank, while the equity consists of ordinary share capital. Interest on the loan is charged at a rate of 10% per annum. The yield on government bonds is 8.20%. InstaJets Ltd has a beta of 1.30. The market risk premium is 6%.

Required: 2.1 Calculate InstaJets Ltds weighted average cost of capital. (5) 2.2 Explain the potential problem in evaluating a project without adjusting the cash flows for inflation, and calculate the discount rate that would be appropriate for dealing with such un-inflated cash flows. (3) 2.3 Appropriately evaluate the two options outlined in the scenario above, and recommend which of the two options InstaJets Ltd should choose. (22)