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Bachelor of Business
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Managerial Finance 367910
Semester 2, 2015
INDIVIDUAL ASSIGNMENT 2
Course Contribution: 30%. (80 Marks)
Due Date: 12PM
Tuesday 19th May 2015
Hand in at: Drop Box Level 1 WF
building
Requirements:
1. In
answering the questions, marks will be awarded for:
(a) Clarity of discussion and analysis;
(b) Correctness of content materials;
(c) Logical flow of the discussion involved;
(d) Quality of
communication, e.g. correct spelling, grammar and sentence structure, proper
page numbers and correct referencing used.
2. All assignments
should be headed with a bar-coded signed cover sheet which you can download
from arion. Instructions on retrieving the cover sheet is on AUT Online
3. This assignment must
not be done in teams which involve sharing of information. Students are
required to work independently.
4. This assignment must
be fully typed, one sided with double-line spacing using 12 font Arial. Any references and quotations taken from
other authors must be properly acknowledged.
5. A
hard copy of the assignment is to be handed in at the drop box on level 1 of
the WF building. A soft copy will also need to be submitted to Turn-it-in by 12PM,
19th May 2015
Monkey Manufacturing
Ltd
Sebastian
Henry was well known for his bad temper. He was screaming at his general sales
manager, screaming at his executive assistant, and screaming into the telephone
at his manager of executive travel. As founder, president and CEO at Monkey
Manufacturing Ltd, a $60 million dollar sporting goods retailer with sales
outlets located in 42 states, you might think that Sebastian’s flare-up would
intimidate his staff. In fact, they were used to his sudden outbursts. When he
was out of the office, the firm’s headquarters staff quietly jokes that you
could tell when Sebastian was getting ready to blow by watching his ears.
Whenever his blood pressure started to rise, the tips of Sebastian’s ears would
turn bright red and begin to twitch, and the angrier he became the more they
would twitch. Yes, Sebastian was a hyperactive kind of guy, and Monkey
Manufacturing was a high-stressed place to work.
As
Sebastian slammed down the telephone, none of the corporate officers needed to
check his ears since it was quite obvious he was furious. Here he was, he
complained loudly to anyone within earshot, sitting at corporate headquarters
at Amarillo, Texas when he needed to be in Peoria, Illinois in just three hours
for the regional sales meeting. The executive travel manager had just informed
him that this was physically impossible because the next scheduled flight to
Peoria would not leave Amarillo until 9.00 the next morning. He would just have
to miss the manager’s meeting at the Peoria store – unless he chartered a private
jet out of Amarillo. Unfortunately private jets were hard to come by in
Amarillo with little more than three hours notice.
As
Sebastian started to calm down, he started to realise that it might be a good
time for Monkey Manufacturing to consider a permanent change in the firm’s
corporate travel arrangements. At present, the firm’s steadfast travel policy
required all executives to fly economy on scheduled commercial airline flights
– no chartered jets, no first class upgrades. By 1996, the firm had grown to
include retail locations in modestly populated states like Iowa, Wyoming, Utah
and Arkansas. Trying to reach the far-flung corners of the corporate empire
using commercial airlines had become a logistical nightmare, and Monkey
Manufacturing’ executives were wasting far too much time sitting in airports
waiting for connecting flights to their final destinations.
While
Sebastian had an excitable personality, he was also a fairly astute business
manager. He realised that corporate jets were quite expensive, and until
recently, Monkey Manufacturing had been unable to justify such an extravagant
purchase. On days when the plane sat parked at the airport, the firm would have
to pay it’s full time flight crew anyway. When the chief pilot got sick or the
plane went into the shop for maintenance, managers would have to resort to
commercial airline flights. Even worst, Sebastian knew that the no-nonsense
institutional investors who owned a large block of Monkey Manufacturing common
equity would take a dim view of pampered managers flying in corporate luxury at
their expense.
Still
he realised that it was vital for the headquarters staff to communicate
regularly with retail managers in the field, and more often than not, the best
way to communicate was a face-to-face meeting. To accomplish these site visits,
Sebastian and his senior management staff were spending an increasing amount of
time in the air. Table 1 provides a summary of the current travel statistics at
Monkey Manufacturing showing that executives made 48 round trip flights from
Amarillo headquarters during the year. Even with careful effort to reduce
executive travel, airline usage at Monkey Manufacturing was growing by 5% each
year. Table 2 summarises the firm’s expected travel plans in each year of the next
10 years.
Upon
further investigation, Sebastian was able to assemble all of the travel costs
and pricing data shown in table 1. At this point he was sincerely interested in
establishing a new corporate travel policy for the coming decade at Monkey Manufacturing.
The change would be difficult however because the various options confronting
him were somewhat technical and not directly comparable to one another.
Moreover Sebastian was concerned that the company had just spent $250,000 in
the previous fiscal year to revamp the way the firm managed executive travel,
adding expensive computer hardware and a proprietary software scheduling system
to help coordinate the busy executive travel schedule at the firm. Changing the
corporate travel policy at this juncture would most likely make the firms
recent investment obsolete.
In
spite of this potential loss, Sebastian felt it was time for a change. The
software management system was simply not able to keep up with the frantic
schedule of the firm’s executives, and the headquarter team needed to spend
more time in the field. After reviewing his options, Sebastian identified three
alternative courses of action he would consider:
- Contract Flight Times on Commercial Carriers
This option would require the smallest
change to Monkey Manufacturing’s current travel policy. Executives would
continue to fly economy on scheduled commercial flights, but under a series of
annually renewable contracts with a major domestic airline, Monkey
Manufacturing average ticket price would be $1,000, and first class upgrades
would be available for an additional $300 per ticket. The frequent flier
discount shown in table 1 could be used to reduce both of these fares, however
ticket prices were subject to annual price increases under the terms of the
contract.
Even worse, Monkey Manufacturing would be
required by the airline holding the contract to book reservations at least
three business days in advance of the intended departure date, and the firm’s
executive would be required to make all connecting flight arrangements through
the same carrier. The final limitation meant that Monkey Manufacturing
travelling executives could look forward to an average delay of around four
hours per round trip flight as they awaited connecting flights in airport
terminals. In addition the form would need to continue staffing the executive
travel manager’s position to coordinate executive travel arrangements. Given
these drawbacks and the cost uncertainty associated with annual ticket price
increases, Sebastian viewed this option as the most risky solution to the
firm’s travel problems.
2. Private Aircraft Purchase
As the second alternative, Monkey
Manufacturing could purchase a new Cessna Citation II corporate jet for $2.5
million. With a range of 1600 nautical miles on a full tank of gas, the
corporate jet could reach each of the retail stores without the need for
intermediate refuelling. The plane could have a 10 year useful life at Monkey
Manufacturing and would be depreciated on a straight line basis over an 8 year
period toward a 20% salvage value. At the end of its 10 year service life,
Sebastian was assured that the plane would easily bring a price of $325,000 in
the used aircraft market.
Unfortunately, jet ownership would
require Monkey Manufacturing to bare the cost of hiring a flight crew and
maintaining the airplane. Table 1 details the fixed and variable operating cost
estimates as well as the forecasted annual price increases associated with
these costs. There were a few advantages provided by this option, however. By
purchasing the plane now Monkey Manufacturing would avoid any price increases
associated with the rising price of jet aircraft over the next decade. In
addition a corporate jet would eliminate practically all of the dead time that the
firm’s executives were spending in airports. Even better, the plane would be
available on a moment’s notice so Sebastian could get from Amarillo to Peoria
with little advance planning. Finally Monkey Manufacturing would no longer need
an executive travel manager to coordinate and manage executive travel plans.
The more Sebastian considered this possibility, the better it looked. He rated
it the lowest risk alternative of the three options.
3. Corporate Aircraft Time Sharing
A third and final option offered an
intriguing possibility for Monkey Manufacturing. For just $630,000 the firm
could acquire a 25% ownership interest an a Citation II from Jet Share Inc., a
Fort Worth firm providing corporate clients with timeshared use of jet
aircraft. Monkey Manufacturing would share ownership of the jet with other
firms, and company executives could have exclusive use of the plane for flights
anywhere in the continental United States with just two hours advance notice.
Monkey Manufacturing would be charged $1060 per hour of flight time for direct
operating expenses and the firm faced fixed costs of $134,580 in each year of
the time share contract. Each of these costs would remain constant for the
duration of the time-share contract.
The good news was that Monkey
Manufacturing could depreciate its ownership share of the plane on a straight
line basis over the five year term of the time share contract toward a 20%
salvage value. At the end of the contract, Jet Share would repurchase the plane
at it’s book value, and establish a new 5 year time share contract using a new
plane. In addition, with only two hours advance notice required for departures
from Amarillo, the executive travel manager’s position at Monkey Manufacturing
could be eliminated. The bad news was that the replacement time share contract
would carry prevailing market prices and Monkey Manufacturing would bare the
risk of price increases for new aircraft as well aircraft operating
expenditures, after just five short years. According to Jet Shares promotional
literature, customers could expect these price increases to average about 4%
each year.
Given the novelty of the time-share
contract and the fact that jet share did not have much of a track record,
Sebastian was a little hesitant to endorse this option. At the same time, this
plan required virtually no connecting flights and offered greater price
protection than the contract arrangement with a commercial airline. All things
considered, Sebastian rated the risk level of this option higher than the
aircraft purchase option but lower than the contract option with a commercial
carrier.
With all the facts on the table, it was
time to get them organised and make a decision. Monkey Manufacturing had
enjoyed 5 years of steadily rising sales and profits, yet the firm’s managers
were not comfortable making multi-million dollar capital acquisitions at the
drop of a hat. In addition, Sebastian was worried that a corporate jet might be
viewed by outside directors and shareholders as an unnecessary extravagance.
Most certainly travel by private jet would provide first class accommodations
for the firm’s management team and the corporate travel policy had always
required the austerity of economy flights even for Sebastian. Finally, Sebastian
realised that he could ill afford to disappoint the board with an inappropriate
capital expenditure. Just last month they gently and firmly admonished him to
treat his employees with greater respect and control his temper. The Board was
clearly satisfied with the sales and profit growth Monkey Manufacturing enjoyed
under Sebastian’s leadership, but privately many board members were beginning
to express reservations that the financial end did not necessarily justify the
management means. As Sebastian retired to his office to consider his options,
he realised he needed to make a decision – but more important he needed to make
the right decision.
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4.
Jet Aircraft ownership costs (Cessna Citation II)
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Acquisition cost
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$2,500,000
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Range (nautical miles)
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1,600
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Passenger seating
capacity (excluding crew)
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7
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Direct operating cost
summary (per hour of flight)
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Fuel
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$400
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Crew
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$250
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Maintenance
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$167
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Total Direct operating
costs
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$817
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Annual Fixed Cost
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$204,528
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5.
Projected Annual Price Increase for Travel Related Expenditure (%)
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A: Salaries
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Travel Office personnel
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4%
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Flight Crew
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6%
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Executive Travelers
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8%
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B. Commercial Air Fares
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Economy tickets
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6%
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First class tickets
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6%
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C: Capital Expenditures
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Jet Aircraft Prices
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3%
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Fuel Costs
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8%
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Maintenance Costs
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5%
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Fixed Expenses
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4%
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Capital Cost
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3%
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6.
Risk Adjusted Corporate Capital Costs (after tax)
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Low risk projects
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7%
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Average risk projects
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10%
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High Risk Projects
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14%
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Corporate Tax Rate
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40%
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TABLE 2
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Monkey Manufacturing Ltd
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Executive Travel Forecast
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-
Years -
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1
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2
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3
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4
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5
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6
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7
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8
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9
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10
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Number of
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Round Trip
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50
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53
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56
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59
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62
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65
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68
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71
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75
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79
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Flights
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QUESTIONS
1.
Given
that each of the three corporate transportation alternatives covers a different
length of time, what time period should be used to compare these options? (2 Marks)
2.
In
constructing the cash flows associated with each option, how should the analyst
treat Monkey Manufacturing $250,000 expenditure for computer hardware and
software to coordinate its executive travel schedule? Why? (2 Marks)
3.
In
constructing the cash flows associated with the commercial airline contract
option, should the analyst include: (a) the average cost of economy tickets;
(b) the cost of upgrading an economy fare to a first class ticket; and/or (c)
both of these ticket prices? Be sure to explain your answer, and indicate how
each of these costs would appear in the capital budgeting analysis. (4 Marks)
4.
In
constructing the cash flows associated with the commercial airline contract
option, should the analyst include the lost time that Monkey Manufacturing
travelling executives spend waiting for connecting fights in airport terminals?
If so, how should this time be represented in each year of the capital
budgeting analysis?(6 Marks)
5.
What
is the annual depreciation expense that Monkey Manufacturing may claim against
taxable income under each of the three travel options? (6
Marks)
6.
Does
each of the three travel options contain a different risk level? If so, how
should the analyst incorporate the risk differential within the capital
budgeting analysis? Be sure to identify the appropriate discount rate necessary
to evaluate each alternative in answer, and explain your selection of each
particular discount rate. (6 Marks)
7.
Should
the capital budgeting analysis include the forecast inflation rates shown in
Table 1? If so, demonstrate how each of these inflation factors will affect the
various cash flows in the capital budgeting analysis. (8 Marks)
8.
What
is the net salvage value that Monkey Manufacturing can expect to receive from
(a) the aircraft purchase option, and (b) the aircraft time share option?(4 Marks)
9.
Based
on your answer to question 1 through 8, prepare a schedule of corporate cash
flows relevant to each of the three travel alternatives, and calculate the
present value of the total cost of each option. In developing the cash flows,
assume that capital expenditures necessary to fund a change in Monkey
Manufacturing travel policy occur in the current period (Year 0) and all
operating expenditure begins in the next fiscal year (Year 1). (18 Marks)
10.
In
question 9, should the analyst focus on before tax or after tax cash flows?
Why? (2 Marks)
11.
The
case describes that Monkey Manufacturing has enjoyed several years of growing
profitability. How does this information influence your answer to question 10?
If the case included information that led you to believe that Monkey
Manufacturing would suffer several years of financial losses over the next
decade, how would this new information change your estimates of project cash
flows expected from each of the three travel alternatives ? (3 Marks)
12.
In
evaluating capital budgeting projects with different project lives, financial
analysis often use a technique called the Equivalent Annual Annuity. Would this
technique be useful in this case to evaluate the three travel alternatives? Why
or why not? (4 Marks)
13.
Is
Sebastian Henry’s assessment of the risk level of each travel alternative
sufficient justification for the financial analysis to apply different discount
rates to each of the three travel alternatives? Why or why not? (9 Marks)
14.
All
things considered, which of the three should Sebastian select? Be sure to
justify your answer on the basis of (a) your capital budgeting analysis of the
three travel alternatives, and (b) the contextual information provided by the
case. (6 Marks)
[TOTAL
80 MARKS]
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