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06Feb

Travel Business Fullfrog Management Assignment

Fullfrog Management Assignment

Fullfrog Travel (FT) is in the business of providing photographic guides with flying facility for aerial photography. As it does not have its own aircraft, it relies on a local aviation company, Aerostar Aviation (AA) for the flying services. AA charges heftily and this is not liked by the Managing Director of FT. She is considering various options to find a possible solution to this, namely:

  • Option 1: Status quo; continue association with Aerostar Aviation
  • Option 2: Borrow money and purchase a second-hand aircraft; use & sell after five years
  • Option 3: Option 2 + additional rentals from leasing of aircraft
  • Option 4: Option 3 + Increase in scope of job description of the pilot

Evaluation of the possible options for Fullfrog Management Assignment

In this section, we will evaluate all the above listed possible options with a balanced approach and will try to find which option is best suited for this organization, in terms of monetary as well as operational aspect.

Standard Assumptions

To facilitate any evaluation process including the financial analysis requires considering certain basic standard assumptions for the process. Standard assumptions considered during this study are stated below:

  1. The costs considered upfront would be the only costs incurred by the company. No additional costs other the mentioned ones, will be borne by FT
  2. All the revenues and expenses have been stated at real values for the current period and no inflation is recorded in the analysis as the inflationary increase in receipts will automatically offset the inflationary increase in expenses.
  3. Depreciation on aircrafts is assumed to be 10% under Straight Line of Method (SLM) for accounting of depreciation.
  4. Tax rate is taken to be 30%
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Option 1: Status quo; continue association with Aerostar Aviation (AA)

AA charges £200 per hour for the hire of aircraft and pilot (inclusive of all other charges). The company uses the flying services for around 400 hours annually which translates into an annual charge of £80,000 for FT. Considering that the other option is to purchase and operate an aircraft for a period of five years; we calculate the cost under this option to facilitate comparability between options. Operation under this option would cost £400,000 to the company under the standard assumptions.

Option 2: Borrow money and purchase a second-hand aircraft; use & sell after five years

Owning and operating an aircraft would involve various costs. Under this option FT will borrow £48,000 at current cost of capital of 10% and operate it for a period of five years. After the completion of five years, it intends to sell the aircraft at a realizable value of £24,000. The interest on borrowing is assumed to be paid annually for the period of five years resulting into a regular outflow of funds.

Operating costs are primarily fixed on yearly basis except for the fuel and landing & handling charges as they are charged on usage basis. On an average basis, FT uses the aircraft for about 400 hours in a year and each flying is averaged to be of 2 hours; thus resulting into a landing and handling fees for 200 flights.

Considering the standard assumptions, it is taken that the costs will increase on account of inflation; however as the entire analysis is pegged at current prices, we do not need to show the nominal values post inflationary increase.

Benefits of charging depreciation

Since FT will own the aircraft, it will charge depreciation to its books. It will benefit the company as it is a non-cash expense; however it can enjoy the advantage of tax shield from the amount of depreciation. Taking depreciation of 10% for the aircraft and a tax rate of 30% provides a tax shield of £7,200. The company can enjoy the benefits of this tax shield only if the ongoing business operations is profit-making and hence it can save by paying lesser taxes to the tune of £7,200.

Total cost

Owning and operating an aircraft would result into a total cost of £438,000 which also includes the inflow of cash from re-sale of aircraft but excludes the benefits from charging depreciation. It is comparatively costlier as compared to the first option.

If we consider the benefits of depreciation, the total cost would be £430,800 for owning and operating the aircraft for a period of five years.

Option 3: Option 2 + additional rentals from leasing of aircraft

This option explores the possibility of leasing the aircraft to another user to make optimum utilization of the asset. This will result into additional inflow of funds to the organization.

We need to critically evaluate if the incremental cash flows from this add-on option are positive or not. If the incremental cash flows are positive, this add-on option can be implemented; else it will be dropped.

A guaranteed flying time of 120 hours per annum at a charge of £180 excluding landing fees (paid separately by the client) would result into a good cash inflow for FT. The additional costs to be borne by FT are insurance and maintenance which would increase by 30% on implementing this model.

Crunching the numbers shows that this deal would be beneficial for the company as it would have a positive annual cash flow of £12,960 translating into £64,800 for a period of five years.

As per the calculations, the Net Present Value (NPV) of this additional business dealing is positive; hence we can definitely go with this add-on package. As a matter of fact, the inclusion of this add-on package makes the entire aircraft deal a profitable option for the company.

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Option 4: Option 3 + Increase in scope of job description of the pilot

The last option is the extension of Option 3 to include the possibility of including the job description of a pilot to include certain mundane activities. Considering that the pilot also looks after maintenance and flight planning; still he is left with approximately 500 working hours in a year. The management wants to explore the remote possibility of assigning the duties of driving a car and general office works to the pilot.

This option is not at all viable and has to be ruled out at the outset. It is so because a highly qualified and technical expert like a pilot cannot be asked to do petty things like driving a car and general office work. It is not the optimum utilization of resources by the company. A technically qualified and experience personnel should be assigned job duties which are demanding and do justice to the amount of salary he is drawing. Another individual can be hired for the job of driving and general office work that is less technically qualified.

As far as the unused working hours of the pilot are concerned, it has to be critically handled by FT. A model can be worked out wherein the services of the pilot are hired on hourly basis and hence there would be no idle wastages.

A detailed analysis of all the possible options shows that using the third option would be the most viable option for the company.

Total outflow for a period of 5 years
W/o tax shield from depreciation With tax shield from depreciation
Option 1 £400,000 £400,000
Option 2 £438,000 £430,800
Option 3 £373,200 £366,000

Sensitivity Analysis

We have undertaken a comprehensive sensitivity analysis on all the three possible options. Break-even point (BEP) analysis

Assuming that the overheads remain constant with change in flying hours, we have carried a break-even analysis.

BEP in case of no tax shield

If the company will not enjoy any tax shield from depreciation, then the break-even point comes to be the following:

Breakeven point (without tax shield on depreciation)
Option 2 Option 3
Option 1 462 flying hours 356 flying hours

It would be beneficial for the company to opt for option 1 if the flying time is going to be less than 462 hours in a year. If it is going to be more than 462 hours; then Option 2 is viable for the company. Similarly, the cut-off point is even lesser in case the third option is considered. If the firm thinks of leasing the aircraft for unused hours, then in that case, Option 1 will be beneficial only if the flying hours are less than 356 hours. Anything in excess of 356 flying hours would mean that the third option is preferred.

BEP in case of tax shield from depreciation

If the company will not enjoy any tax shield from depreciation, then the break-even point comes to be the following:

Breakeven point (with tax shield on depreciation)
Option 2 Option 3
Option 1 450 flying hours 344 flying hours

The break-even point becomes 450 flying hours in case of comparison of Option 1 and Option 2; anything in excess of 450 hours would mean that Option 2 is beneficial rather than Option 1. Similarly if we compare Option 1 and Option 3, anything in excess of 344 flying hours would mean that the Option 3 is preferred over Option 1.

Conclusion

A look at the possible options shows that it would be beneficial for the company to own and operate an aircraft as well as to lease the aircraft for the unused flying hours. This option is beneficial for the following reasons:

  1. It is financially more preferred as compared to any other options because it results in the lowest amount of cash outflow for the company.
  2. It mitigates business risk to a large extent, as under this option we are leasing the aircraft in times when it is not required for photography, hence ensuring regular inflow of funds.

References

  1. Brealey – Meyers, 2003. “Principles of Corporate Finance”, Seventh edition, The McGraw Hill Companies.
  2. Parrino & Kidwell, 2009. “Fundamentals of Corporate Finance”, John Wiley and Sons.
  3. Brigham, Eugene F. and Houston, Joel F., 2007 “Fundamentals of Financial Management”, Cengage Learning.
  4. Almeida, H., M. Campello, and M. Weisbach, 2004, “The Cash Flow Sensitivity of Cash,” Journal of Finance 59 (No. 4, August), 1777-1804
  5. Scott, D. J., and W. Petty II, 1984. “Capital Budgeting Practices in large American Firms: A retrospective analysis and synthesis.” Financial Review 19 (No. 1 March), 111-123
  6. Bierman, H., 1993, “Capital Budgeting in 1992: A survey,” Financial Management 22 (No. 3, Autumn), 24.
  7. Booth, L., 1996, “Making capital budgeting decisions in Multinational Corporations,” Managerial Finance 22 (No. 1), 3-18