United Overseas Airline (UOA)Company

The United Overseas Airline Co. was founded five years ago by three Airline employees of TWA and Pan American airlines Company employees. The three founders own 100% of the United Overseas Airline Company's stock which has a market value of $5 per share. Below is the Balance Sheet of the company.

United Overseas Airline Company -Balance Sheet

Cash

$100,000

Accounts Payable

$150,000

Account Receivable

$300,000

Notes Payable

$50,000

Inventory

$250,000

Accrued Wages

$75,000

Current Assets

$650,000

Current Liabilities

$275,000

Gross Fixed Assets

$1,850,000

Common Stocks (1M shares at par value of $1.5)

$1,500,000

less: Accumulated

Depreciation

($300,000)

Retained Earnings

$425,000

Net Fixed Assets

$1,550,000

Equity

$1,925,000

Total Assets

$2,200,000

Total Debt & Equity

$2,200,000

The boards of directors of United Overseas Airline Company have asked Frank Norman, the financial officer of the company, to make the first major decision for the company's future financial planning.

The board has asked Frank to evaluate the profitability of two new small private jet each cost one million dollars and two medium size jet each costing $2.5 million dollars. (Table 1) show the information for both jets.

Table 1

Small Jets

Medium Jets

Purchase Price for two jets

$2,000,000

$5,000,000

Annual passenger

3,000

3,000

Annual growth in passengers

5%

5%

Service cost per passenger

$600

$600

Annual growth in service cost per passengers

3%

3%

Ticket price per passenger

$1,100

$1,250

Ticket price Increase

4%

4%

Beta

1

1.4

Tax Rate

40%

40%

All jets would be depreciated on a straight-line basis over their five-year life to a zero-salvage value.

Frank Norman, being a sophisticated financial analyst, obtained the following information in

Table -2 for the analysis of various investment and financial proposals.

Table 2

Expected Return

Variance

Covariance with Market Return

Risk-Free Rate

6%

Market Portfolio

20%

Rate of return on the Market

12%

United Overseas Airline

8%

Part I

1.What is the cost of capital for each investment?

2.Which of the two investments should be adopted? Why?

3.What would be the United Overseas Airline 's cost of capital if these two investments are adopted?

4.Based on the expected rate of return of each investment which investment should be accepted? Why?

Part II

The UOA does not have any debt in its capital structure and some debt would be beneficial to the company. Frank proposed to the board of directors the company should finance half of each investment in jets by debt at the 10% interest rate and retire the debt over the life of the investment. If Frank Norman is correct with his assumptions and if his financial plan is adopted, what would the following be?

1.What is the Adjusted Present Value (APV), for Small and Medium size jets?

2.What would be the value based on the Weighted Average Cost of Capital (WACC)?

3.What is the Cash Flow-to-Equity (FTE) for Small and Medium size jets?

4.Explain the differences among the three methods for the level of debt financing.