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

Cost of equity by using CAPM = Risk free rate+(Maret risk premium*Beta) = 2.5%+(7%*2.8) = 2.5%+19.6% = 22.1%

Cost of Redeemable Debenture (Kd) (RV-NP (1-t)+ n (RV+NP) 2 Where, - NP = Interest payment = Net proceeds from debentures in case of new issue of debt or Current market price in case of existing debt. = Redemption value of debentures = Tax rate applicable to the company Remaining life of debentures. RV t n

Coupon(I) per 6months = Face value*Coupon rate/2 = 1000*14%/2 = 70

NP = 1,250 RV=1,000 t=0.25 n=20years*2 = 40 periods

Cost of debt after tax = {[70*(1-0.25)]+[(1,000-1,250)/40]}/[(1000+1250)/2] = {(70*0.75)+(-250/40)}/(2250/2) = (52.5-6.25)/1125 = 46.25/1125 = 4.11% per 6months period = 8.22% per annum

Computation of hurdle rate:

Type	Market value	Proportion (Market value/ΣMarket value)	Cost after tax	Cost of capital (Cost after tax *Proportion)
Common stock	116,000,000	65.00%	22.10%	14.37%
Debt	62,500,000	35.00%	8.22%	2.88%
	178,500,000			17.24%

Cost of capital or hurdle rate = 17.24%

Sl No	Years	0	1	2	3	4	5	6	7	8	9	10
i	Revenue (Previous year*98%)		8,250,000	8,085,000	7,923,300	7,764,834	7,609,537	7,457,347	7,308,200	7,162,036	7,018,795	6,878,419
ii	Annual Maintenance (Given)		150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000	150,000
iii	Salary to pilot (Given)		250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000
iv	Variable cost (Previous year*98%)		2,250,000	2,205,000	2,160,900	2,117,682	2,075,328	2,033,822	1,993,145	1,953,282	1,914,217	1,875,932
v	Feeding cost (Given)		450,000	450,000	450,000	450,000	450,000	450,000	450,000	450,000	450,000	450,000
vi	Other fixed cost (Given)		1,250,000	1,250,000	1,250,000	1,250,000	1,250,000	1,250,000	1,250,000	1,250,000	1,250,000	1,250,000
vii	Depreciation (10.3million/10years)		1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000
viii	EBIT (i-ii-iii-iv-v-vi-vii)		2,870,000	2,750,000	2,632,400	2,517,152	2,404,209	2,293,525	2,185,054	2,078,753	1,974,578	1,872,487
ix	Tax @ 25% (viii*0.25)		717,500	687,500	658,100	629,288	601,052	573,381	546,264	519,688	493,645	468,122
x	PAT (viii-ix)		2,152,500	2,062,500	1,974,300	1,887,864	1,803,157	1,720,144	1,638,791	1,559,065	1,480,934	1,404,365
xi	Add back: Depreciation		1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000	1,030,000
xii	Operating cash flow (x+xi)		3,182,500	3,092,500	3,004,300	2,917,864	2,833,157	2,750,144	2,668,791	2,589,065	2,510,934	2,434,365
xiii	Investment (Given)	-10,300,000
xiv	Net cash flow (xii+xiii)	-10,300,000	3,182,500	3,092,500	3,004,300	2,917,864	2,833,157	2,750,144	2,668,791	2,589,065	2,510,934	2,434,365
xv	PVF @ 17.24%	1.00	0.8530	0.7276	0.6206	0.5293	0.4515	0.3851	0.3285	0.2802	0.2390	0.2039
xvi	Net present value of cash flow (xiv*xv)	-10,300,000	2,714,673	2,250,103	1,864,469	1,544,425	1,279,170	1,059,080	876,698	725,456	600,113	496,367

Net present value = ΣNet present value of cash flow = 3,110,554

Payback period:

Year	Net cash flow	Cumumulative cash flow
0	-10,300,000	-10,300,000
1	3,182,500	-7,117,500
2	3,092,500	-4,025,000
3	3,004,300	-1,020,700
4	2,917,864	1,897,164
5	2,833,157	4,730,321

Payback period = Year before the year in which cummulative cashflow turns into positive+(1st positive cummulative cashflow/cashflow in the year in which cummulative cashflow turns into positive) = 3years+(1,897,164/2917,864) = 3years+0.65year = 3.65years

A B C D E F G H - J K L M 1 2 - 3 4 5 6 7 8 9 SI No Years Revenue Annual Maintenance jii Salary to pilot iv Variable cost V Feeding cost vi Other fixed cost vii Depreciation viii EBIT ix Tax @ 25% х PAT xi Add back: Depreciation xii Operating cash flow xiii Investment xiv Net cash flow IRR Formula 0 1 2 3 4 5 6 7 8 9 10 8,250,000 8,085,000 7,923,300 7,764,8347,609,5377,457,3477,308.2007,162,0367,018,795 6,878,419 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 150,000 250,000 250,000 250,000 250,000 250,000 250.000 250,000 250,000 250,000 250,000 2,250,000 2,205,000 2,160,900 2,117,682 2,075,328 2,033,822 1,993,145 1,953,282 1,914.217 1,875,932 450,000 450,000 450,000 450,000 450,000 450,000 450,000 450,000 450,000 450,000 450,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,250,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 2,870,000 2,750,000 2,632,400 2,517,1522,404,209 2,293,525 2,185,054 2,078,753 1,974,578 1,872,487 717.500 687,500 658,100 629,288 601,052 573,381 546,264 519,688 493,645 468,122 2,152,500 2,062,500 1,974,300 1,887,864 1,803,1571,720,144 1,638,791 1,559,065 1,480,934 1,404,365 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 1,030,000 3,182,500 3,092,500 3,004,300 2,917,864 2,833,157 2,750,144 2,668,7912,589,065 2,510,934 2,434,365 -10,300,000 -10,300,000 3,182,500 3,092,500 3,004,300 2,917,864 2,833,157 2,750,144 2,668,791 2,589,065 2,510,934 2,434,365 25.67% ;=irr(C15:M15) 10 11 12 13 14 15 16 17

Management decision:
Since the Payback period is less than 4years, NPV is positive & IRR is more than hurdle rate hence accept the dragon project.