PrivateJets (PJ) is considering expanding its operations in the corporate travel market.
Currently, PJ has a capital structure with a 25% debt-equity ratio. Their levered equity has a β of 1.5; theirdebt has a β of 0.1. The risk-free rate is 5%, and the expected return on the market is 10%.
The proposed project is in the same line of business as existing operations, and is expected to generate cashflows over a period of 10 years. Annual expected pre-tax revenues would be $20 million (times 1 to 10).Annual expected pre-tax costs would be $8 million (times 1 to 10).
PJ currently leases planes to several small commuter airlines. PJ's analysis projects that if its corporate jetproject is successful, there will be less demand for these leases in the future. PJ's current lease contractsrun through year 5. PJ projects that the new contracts in year 6 will fall in value by $10 million (value atyear 6 of all the lost future after-tax cash flows) if the new project goes ahead.
PJ also projects that its current booking and sales capacity can handle the expanded operations through year 3, but in year 4 overhead expenses for the company will increase from $4 million per year to $5 million per year (and remain at that level through the rest of the project).The project will initially (year 0) require a working capital account of $4 million, which will have to beincreased to $6 million in year 4, and increased again to $8 million in year 8. The total amount in theworking capital account can be recovered in year 10 after the project is completed.
New planes will be purchased in year 0 at a total cost of $20 million. They can be depreciated over 5 yearsusing straight-line depreciation. At the end of the project, they would have an after tax market value of $11million in year 10. PJ can also use 2 of its existing planes starting in year 6 when their leases expire. Theseplanes are completely paid for and depreciated for tax purposes, and they could each be leased out for $1million per year (before taxes). At the end of this project, they will be returned to the leasing operation.
PrivateJets contracted with a consulting firm to analyze the market potential of the new project; the fee forthe report is $0.5 million. Their report has been completed and the first installment of the fee has been paid.An additional $0.25 million is due at time 1 (and the firm intends to make the payment and will notdefault). PJ pays a 35% marginal corporate tax rate.
a) Find the weighted average cost of capital (WACC).
b) Should PrivateJets proceed with the project? If the expansion is undertaken, how does it change the value of the firm?
c) Suppose that PrivateJets can spend an extra $0.25 million per year (years 1-10) onmaintenance of the newly-purchased planes described above. If it does so, the planes would retaintheir value and their after-tax market value in year 10 would be $20 million (instead of the $11million described above). What is the equivalent annual cost (or benefit) of increasing themaintenance? Should the firm undertake the higher maintenance schedule?