Question

DragonFlights, Inc. is planning on purchasing a new flying dragon for their new route to Volantis. The cost of the dragon is $10.3 million. On average the dragons are operational for about 10 years. Dragon will be retired after 10 years with no salvage value. Marketing department of DragonFlights has conducted consumer surveys and market research in order to determine market demand and estimate future sales. This research has cost them $100,000. Based on the results of market studies management of the company estimates that they can make 150 flights per year on the new route the 1st year of operations. Each flight will generate sales of $55,000 per flight. Revenues are expected to decline 2% per year as the dragon gets older and doesn't have the energy to make as many flights per year. Annual maintenance of the dragon will cost the company $150,000. Salary of the dragon pilot is $250,000 per year. Variable costs per flight are $15,000. Feeding the dragon will cost the company $450,000 per year. Other fixed costs per year are $1.25 million. Tax rate is 25%. DragonFlights has reset criteria for approving capital projects. Payback period has to be four years or less, NPV has to be positive and IRR has to beat the hurdle rate. DragonFlights uses their cost of capital as hurdle rate. DragonFlights is currently financed with common equity and debt in the form of bonds. They have 1 million shares outstanding and shares are trading at a price of $116 per share. Stock beta is 2.8 as dragon flying business is a risky business. Company is also financed with publicly traded bonds in the total amount of $50 million in book value with 50 thousand bonds outstanding. Bonds are trading at premium at for $1,250 per bond. Bonds have 20 years to maturity and have a coupon rate of 14%, with coupon paid semi-annually. Bonds have a face value of $1,000. Current risk-free rate is 2.5% and market risk premium is 7%. Marginal tax rate is 25%.

Answer 1

(a) Year Operating Cash Flow Cash outflow Net Cashflow Depreciation Net profit Tax Cashflow after tax (a) (b) (g=fx 25%) 1,03,00,000 1 2 w 4 38,00,000 36,80,000 35,62,400 34,47,152 33,34,209 32,23,525 31,15,054 30,08,753 29,04,578 28,02,487 (d=b-c) (e) -1,03,00,000 38,00,000 10,30,000 36,80,000 10,30,000 35,62,400 10,30,000 34,47,152 10,30,000 33,34,209 10,30,000 32,23,525 10,30,000 31,15,054 10,30,000 30,08,753 10,30,000 29,04,578 10,30,000 28,02,487 10,30,000 Net Present Value (f=d-e) -1,03,00,000 27,70,000 26,50,000 25,32,400 24,17,152 23,04,209 21,93,525 20,85,054 19,78,753 18,74,578 17,72,487 5 Cumulative PVF @ Discounted Discounted 18.11% Value Value (0) (J=h xi) (k) 1.00 -1,03,00,000 -1,03,00,000 0.85 26,31,022 -76,68,978 0.72 21,63,087 -55,05,891 0.61 17,77,886 -37,28,006 0.51 14,60,863 -22,67,143 0.44 12,00,012 -10,67,131 0.37 9,85,433 -81,698 0.31 8,08,962 7,27,264 0.26 6,63,870 13,91,134 0.22 5,44,610 19,35,744 0.19 4,46,610 23,82,354 23,82,354 (h=d-g) -1,03,00,000 31,07,500 30,17,500 29,29,300 28,42,864 27,58,157 26,75,144 25,93,791 25,14,065 24,35,934 23,59,365 6,92,500 6,62,500 6,33,100 6,04,288 5,76,052 5,48,381 5,21,264 4,94,688 4,68,645 4,43,122 6 7 8 10 Discounted Payback period is the year in which discounted cashflow is recovered that is when NPV being NIL. So in this projection payback period is during 7 year. That is 6.5 year (assuming in middle of the year). Research Fixed Overheads Net cash inflow cost Salary of pilot Feeding cost Working Notes: (i)Net cash inflow (Operating Cash flow): Sales Revenue Variable cost Maintenance Year (2% annual (2% annual cost declining) declining) (+/-) 1 82,50,000 22,50,000 1,50,000 2 80,85,000 22,05,000 1,50,000 3 79,23,300 21,60,900 1,50,000 4 77,64,834 21,17,682 1,50,000 5 76,09,537 20,75,328 1,50,000 6 74,57,347 20,33,822 1,50,000 7 73,08,200 19,93,145 1,50,000 8 71,62,036 19,53,282 1,50,000 9 70,18,795 19,14,217 1,50,000 10 68,78,419 18,75,932 1,50,000 250000 250000 250000 250000 250000 250000 250000 250000 250000 450000 450000 450000 450000 450000 450000 450000 450000 450000 450000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 12,50,000 100000 38,00,000 100000 36,80,000 100000 35,62,400 100000 34,47,152 100000 33,34,209 100000 32,23,525 100000 31,15,054 100000 30,08,753 100000 29,04,578 100000 28,02,487 250000 1st year Flight revenue (150 x $ 55,000) 82,50,000 1st year variable cost (150 x $ 15,000) 22,50,000 * It is assumed variable cost also will be declined by 2% annually as variable in nature, (ii) Depreciation Year Beg. Value Depreciation End. Value (a) (b) (c) (d=b-c) 1 1,03,00,000 10,30,000 92,70,000 2 - 10 92,70,000 92,70,000 Annual depreciation (10300000/10) 10,30,000 (iii) Cost of Equity = Risk free rate + Beta x Risk premium Cost of Equity = (2.5 % +(7% x 2.8) = 22.10% Cost of debt is 14% so, Cost of Capital = (22.10 %x.51)+(14% x.49) = 18.11 % Rough 1000000*116 50000*2250 Millions 116.00 112.50 228.50 Weightage Equity Debt Total 0.51 0.49 1.00