Reference no: EM132605153

Question - ABC Inc is a new company that intends to provide executive jets on hire for use by the CEOs and other senior executives of its client firms. The company is trying to choose between the following two alternative strategies:

Strategy 1:

Acquire second-hand aircraft with a remaining useful life (for the company's purposes) of about 7 years, and replace with similar assets at the end of the useful life.

Appropriate second-hand aircraft can be obtained at a price of about $3.5 million each but, due to their age and lower fuel efficiency, about $2 million would need to be spent on the annual operating and maintenance costs of such an aircraft.

Under the relevant Alternative Depreciation System, ABC Inc will be entitled to claim tax depreciation on the purchase cost on straight line basis over the 7-year period, starting from the first year after purchase.

It is estimated that the residual value of such aircraft on the second-hand market when they are replaced after 7 years would be approximately 30 percent of the price that ABC paid for them.

Strategy 2:

Acquire new aircraft with a useful life (for the company's purposes) of 25 years, and replace with similar assets at the end of the useful life.

Appropriate new aircraft can be obtained at a price of $12.5 million. Although this is more than 3½ times the cost of the comparable second-hand aircraft, advances in design and fuel-efficiency of newer aircraft would result in the annual operating and maintenance costs being about half the level estimated for the second-hand aircraft.

Under the relevant tax legislation, ABC Inc will be entitled to claim bonus depreciation of 50% of the purchase cost of new aircraft in the first year after purchase. The rest of the value would be depreciated on straight line basis over the life of the asset, starting from the first year after purchase.

It is estimated that the residual value of new aircraft on the second-hand market when they are replaced after 25 years would be approximately 20 percent of the price that ABC Inc paid for them. Revenues would be the same under either of the two strategies. All the above figures are before tax, and at current prices. The company pays corporation tax at the rate of 34%, in the year in which the tax liability is incurred. Tax would have to be paid on the resale value realized in respect of any equipment that has been fully depreciated for tax purposes. Although the current inflation rate of 1.5% 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 it would complicate the appraisal.

ABC Inc will be using the following three types of finance, in the ratio of 0.5: 0.2: 1

6.5% secured borrowings

7% mezzanine finance

Ordinary share capital

The mezzanine finance will carry equity kickers and non-equity kickers, the details of which are still under negotiation. The providers of the mezzanine finance would have a second floating charge over the company's assets.

Other Information:

The industry average ratio of debt to equity is 0.5:1.

The industry average beta is 1.09.

The rate of return on the market is currently estimated at 8% annual effective.

The yield on short-dated treasury bills is currently around 0.5%.

Required -

(a) Calculate the weighted average cost of capital of ABC Inc.

(b) Explain the potential problem in evaluating a project without increasing the cash flows at the rate of inflation, and calculate the discount rate that would be appropriate for dealing with such un-inflated cash flows.

(c) Based on the information provided:

i) Schedule the relevant real after-tax cash flows of each of the two alternatives.

ii) Evaluate appropriately and recommend which of the two alternative strategies ABC Inc should choose.