A small airline company called Mancunian Airways (MA) is considering purchasing a new jet, which will be used solely on the new route: Manchester, Paris, Madrid and back to Manchester. The new route will not compete with other existing routes operated by MA. The new airplane costs £2 million. It is estimated that the route will result in additional sales of tickets worth £1.2 million over each of the next 4 years, after which the airplane will be sold. The airplane will be depreciated down to zero over its 5 years economic life using the straightDline depreciation method (this means that you depreciate the machine by the same amount every year). After 4 years the airplane will be sold for £150,000 (we call this the "salvage value" of the airplane). The additional cost to operate the machine is 20% of sales. MA needs to add net working capital of £100,000 immediately for fuel inventory and other expenses. This capital can be recovered in full at the end of the four years. The corporate tax rate is 35%. The required rate of return is 16.55%.
Please note that, when calculating the salvage value, tax liabilities or credits are generated on the difference between the resale value and the book value of the asset. In this case the salvage value of $150,000 is below the remaining book value of the airplane (which I leave for you to calculate). The resulting capital loss creates a tax credit (i.e. you can deduct this loss from your tax payments).
(a) Please calculate the NPV of the investment. Should MA proceed with the investment?
(b) Cite two sources of risk for this investment and mention how they could be reduced or transferred to other parties.
(c) Assume now that this airplane will be used at an existing route (i.e., a route already served by MA). Provide and briefly describe one example of potential incidental effects of the investment in a new jet under this alternative scenario.
(d) The airplane will be parked in the airport in a hangar that belongs to MA. This hangar is currently empty, but another company has approached MA to rent it. Should this rent be included in the NPV calculations? Please justify your answer.
(e) The accounting team has found another legal way to calculate the depreciation of the airplane. More particularly, it suggests that you should accelerate depreciations in the beginning of the lifetime of the airplane, and depreciate less later in its life. Would that accounting change affect the NPV and for what reason? You do not need to provide actual calculations.