AFS / Case Study 6 / Capital Budgeting

HB Aviations is planning to buy a Xian Modern Ark 600 aircraft (60 seats) for commercial use. HB Aviations has done an exclusive tie up with MJ Flight Services, UK, for flight operations and this Joint Venture (HB-MJ Airways Corporation) has a limited life of 5 years, after which, HB Aviations will determine its further growth strategy. The HB-MJ Airways Corporation will have 2 shareholders each contributing equally towards cost of acquiring the aircraft. While considering the option of investing in gold futures which would have given a CAGR of 20% in 5 years on money invested (Capital Gain tax of 20% as against 35% corporate tax on profits), HB Aviations decided to fund the JV Company with Rs. 25 million and opted out of buying the gold future. Strategy & planning team of the JV Company have made the following estimates of seat utilization per days for the 5 years that the JV will be in existence, assuming 365 operating days per year. Year Seat Utilization % 1 30% 2 33.33% 3 50% 4 80% 5 100%

Revenue will be earned only out of operations and there will be no other income. The estimated cost per ticket will be at Rs. 9500, which will remain unchanged throughout the life of the JV Company. Pilots Salary, Fuel & Oil Expenses, and Direct Overheads (maintenance) add up to the total variable cost of the JV Company and will remain constant for the life of the JV Company. The per ticket contribution will be Rs. 2000, after deducting Pilots Salary of Rs. 2,500, Fuel & Oil Expenses of Rs. 3,000 and Direct Overheads of Rs. 2,000. Fixed Cost for operations are Depreciation on the aircraft at 20% WDV and Aircraft Parking charges. Leverage analysis at the EBIT level yield the following Degree of Operating Leverage for the JV Company Year DOL 1 6.00 2 2.50 3 1.50 4 1.20 5 1.12

* Degree of Combined Leverage will be equal to Degree of Operating leverage.

At the end of 5 years, the aircraft is estimated to have a reduced its market value by 90% of its original cost. At the time of liquidating the JV Company, the aircraft will be sold at market value. Considering the above facts, analyze and evaluate if HB Aviations should consider joint venture with MJ Flight Services.