Cheap Jet Company’s Capital Budgeting and Viability Report

Executive Summary

Cheap Jet is a proposed addition to Paul Swift’s ‘ExecAir’ charter plane business. Cheap Jet will operate as a subsidiary of ExecAir and it will only have its independent profits and expenses, while some costs will be shared with the parent company. We have considered the projected ticket sales over the next 15 years based on the 2006 research and also the ticket price that is consistent with Paul’s experience of a plane service.

We have analyzed the Cheap Jet proposal using various tools; including competitor analysis, market analysis, and finally with the financial viability models such as NPV and payback period. We have accepted the PWC’s recommendation to use 12.45% as our discount rate for these purposes. Also, we have realistically inflated our revenues and costs at the inflation rate that is expected to be 2% for the next 15 years. ‘Cheap Jet’ proposal’s viability is firm and impressive, with a positive NPV.

Although the payback period is 7 years, this is still impressive with the overall 15 years of the horizon. Also, this is worth noticing that Cheap Jet starts giving profits from year 4 that is very competitive in the plane-service industry. Based on the results of our findings, we highly recommend the Cheap Jet proposal to evolve as a business venture and start operating immediately. Any delay will no longer hold the model valid for present viability. This recommendation is strengthened by the fact that Paul Swift has a strong experience of operating an aircraft business and the company has a firm platform for a new venture to have a successful operational start.

Assumptions and Relevant Factors

1. The first crucial assumption is that the estimated ticket price and other costs are for the current year, which is year 0. We have inflated the costs and prices from year 1 considering that NPV analysis assumes cash flows occurring at end of each period.
2. The costs that are not inflated are such that are locked or fixed due to a contract or agreement. Fixed costs in our financial model are Insurance premiums, rent (opportunity cost), fuel costs and the per passenger catering cost.
3. Because insurance premiums are paid at beginning of each period, to reconcile the payments for NPV analysis we have brought these payments at the end of each period. (by multiplying with discount factor)
4. We have not considered the research cost of $186,700 because this is sunk cost; something that is never considered in NPV analysis. ( Michel 2001)
5. Similarly, we have not considered the administrative costs and general manager’s salary that will be invoiced to Cheap Jet by ExecAir; because these are already incurred by ExecAir and are not incremental for the proposed project.
6. We have considered the rent that was availed from the premises where Cheap Jet will operate from. This rent will be an opportunity cost and must be considered in NPV analysis.
7. Finally, we have neither considered the cash inflow in Year 0 for debt financing ($37 m for Jets) nor the interest and principal payments; something that is crucial in NPV analysis. The reason is that we want to keep investment and financing decisions separate. Hence we do not deduct principal and interest payments from cash flows for purpose of Net Present Value. At the same time, we assume that the whole initial investment comes from the equity or the owner’s pocket. (Brealey et al. 2004) The discount rate does include the cost to raise the funds that we are ignoring. (Keown et al. 2006)

Other Factors to be considered

The financial model that has been developed has a number of crucial assumptions and consequently, there are some flaws in case the situation is not ideal. Firstly, NPV assumes that the project is going to start immediately. Managers must consider any possible delays and other risk factors that may force to delay or halt the project. (Bahuguna 2000) Secondly, this is almost unrealistic to assume that the discount rate for concern of scale of ExecAir will remain constant for 15 years.

This is a huge risk involved with NPV analysis. The discount rate may change over the years and managers must calculate cash flows discounted by taking multiple discount rates. Thirdly, NPV takes on single values for gains and losses. It ignores a simple risk that the outcome in coming years may be a range of profits or losses. In simple words, NPV does not look at contingencies and other options on its journey to horizon year.

Other financial tools such as IRR and detailed cost-benefit analysis may be carried out but each has its shortcomings. IRR has its criticism and cost-benefit again will be based on projected cash flows. A very effective solution to the flaws of NPV is sensitivity analysis. A sensitivity analysis takes probabilities of different scenarios in future and calculated cash flows based on them. That caters for the risk of the “black box” approach.

For example, Paul must do qualitative research about how much time it would take for another competitor to enter the market because in that case the figures for projected ticket sales of Cheap Jet will be greatly affected. What would be the impact of the non-availability of a jet for some time? Is this realistic to assume the same inflation factor over the next 15 years? Multiple factors will be analyzed before reaching a decision whether to make such an investment and lock into this business venture or not.

References

Michel R.Gregory. (2001). Net Present Value Analysis: A Primer for Finance Officers. Gov. Finance Review.

Brealey, R.A., S.C. Myers, and A.J. Marcus.(2004) Fundamentals of Corporate Finance, 4th ed. New York, NY: McGraw-Hill/Irwin.

Keown, A.J., J.D. Martin, J.W. Petty, and D.F. Scott, Jr. (2006). Foundations of Finance, 5th ed. Upper Saddle River, NJ: Pearson Prentice Hall.

Vimal Bahuguna. (2000). The Myth of Option Pricing. Issued in In Vivo.