The North South Airlines (NSA) is considering two proposals to expand its current operation in a big way. At present, it has a fleet of two Boeing 737-200 jets and four Dornier aircrafts. The B-737s were leased from Wright Airways Inc. of USA. The profits of NSA on a revenue of Rs. 92 crore are Rs. 21 crore.
The Director (Operations) of NSA favours the induction of two additional latest model B737-400 aircrafts. With four jets, the NSA would get the airlines status while its present status is that of Air Taxi Operator (ATO). As a result of achieving the airlines status, the NSA would have to fly on unprofitable routes also. It is suggested that the existing B737-200 models would serve the unprofitable routes. Moreover, Fly-By-Wire Airways (FBWA) is ready to buy one Dornier aircraft for Rs 12 crore whose book value is Rs. 10 crore with remaining useful life of 8 years.
According to an alternative proposal, NSA should acquire an one Airbus-320 (A-320) which has a capacity of 180 passengers compared to 120 of the B737. The NSA would not be required to fly on uneconomical routes with a total fleet of three aircrafts.
On a reference from the managing director of the NSA, the finance manager has worked out the financial parameters as detailed below:
Particulars
Option 1
(Buy 737-400 and sell Dornier)
Option
(Buy A-320)
Cost of aircraft
Staff training
Recurring costs:
Fuel ( 5 % annual increase)
Maintenance
Salary/wages
Insurance premium
Overheads (airport charges)
Sale of Dornier
Recurring revenues:
Profitable routes (10% annual increase)
Unprofitable routes (constant)
Salvage value (after 8 years)
150
2
20
10
5
5
5
12
70
5
30
120
12
8
3
6
3
--
55
--
40
The fuel costs are expected to increase 5 per cent annually, while the likely annual increase in salary, wages and overheads would be 10 per cent. The projected recurring revenues are based on the assumption of average occupancy of 70 per cent on profitable routes and 20 per cent on uneconomical routes.
Assuming 35 per cent tax rate, 10 per cent required rate of return and straight line method of depreciation for tax purpose, how do you evaluate the financial viability of the two proposals? Which one would you recommend and why? Ignore tax shield on staff training costs.