Assignment 1: LASA 2: Airvalue Airways Strategic Planning Airvalue Airways is a regional carrier whose strategy is to expand gradually as they can identify routes that offer an attractive return on the investment necessary to support successful coverage

Assignment 1: LASA 2: Airvalue Airways Strategic Planning

Airvalue Airways is a regional carrier whose strategy is to expand gradually as they can identify

routes that offer an attractive return on the investment necessary to support successful coverage

of the route. As part of this expansion, the company is planning to buy a new plane in the

upcoming fiscal year. The purchasing department has narrowed the choice down to two models.

One is the A220 which is manufactured in Europe. The other plane is the G435 which is built in

the United States. The two aircraft have similar profiles. However, the locally-built G435 is

significantly more expensive to purchase.

The A220 has an expected life of 5 years, will cost $90 million and its use will produce net

operating cash inflows of $30 million per year. The G435 has a life of 10 years, will cost $128

million, and its use will produce net operating cash inflows of $25 million per year. Airvalue

plans to serve the route for 10 years. When they need to purchase a new A220 at the end of five

years, the cost will be $115 million net after allowing for salvage value of the used plane. Net

operating cash inflows will remain at $30 million throughout the second five years. At the end

of 10 years, salvage value of the G435 and of the second A220 are expected to be about the same

at approximately $500,000 each.

As the company’s CFO you are to provide the financial analysis that will be considered by the

strategic planning executive committee during evaluation of this expansion alternative. Your

plan is to use a capital budgeting approach to the analysis in order to best assure that the decision

will result in maximization of wealth for the company’s stockholders. You also want to convert

the entire committee to the concept that capital budgeting should be used as the main tool for the

financial analysis of capital expenditure alternatives.

The company uses the historical difference in returns between the S&P 500 and the Treasury

bond rates of 7% as their estimated market risk premium. The current yield to maturity on a 10-

year Treasury bond is 6.2%. Airvalue Airways’ common-stock equity beta is estimated as 1.40.

Airvalue’s capital structure is 58% common stock, 32% preferred stock and 10% long-term debt.

An 8.8% after tax cost of debt has been determined and the cost of preferred stock is 12%.

Your task is to:

Describe for other members of the strategic planning committee the role that capital budgeting

should play in corporate strategic management.

Explain why the NPV and IRR capital budgeting tools are superior to the accounting rate of

return and simple payback techniques for determining the attractiveness of capital investment

opportunities.

Use the Capital Asset Pricing Model (CAPM) to identify the cost of common stock.

Calculate the weighted average cost of capital (WACC) for the firm’s existing capital structure.

Calculate the net present value (NPV) for each plane model using the company’s WACC as the

hurdle rate.

Recommend which plane should be purchased and justify your recommendation.

Discuss the need to manage implementation of the project so that the higher returns can be

realized. Include the strategic management keys to protecting the project from competitive

forces that would erode the earning power of the project and jeopardize realization of the

projected rate of return on the investment.

To complete this assignment, you must submit a 6-8 page paper that addresses the seven

elements of the task as listed above and exhibits your calculations of the cost of common stock,

the weighted average cost of capital, and the NPV for each plane along with an explanation of

the calculations.