1. Steven Gerrard, the Chief Executive Officer (CEO) of Australian Galaxy Cruises is very excited about the preliminary financial analysis that the company has performed in relation to purchasing a new superliner to be named Pacific Dream. Before Australian Galaxy Cruises invests in the new superliner, a rigorous financial analysis is required to determine whether a new superliner will increase the value of the firm. Shortly after graduating you were hired by Australian Galaxy Cruises as a financial analyst and have so far impressed senior management with your finance knowledge. The CFO (James Milner) has asked you to perform a financial analysis of a new superliner using a purpose-built preformatted EXCEL spreadsheet. Your analysis will be provided to the Board of Directors who will formally decide on the new superliner investment, based largely on your recommendation. The CEO?s and CFO?s salary will stay at $220,000 and $170,000 respectively, if the Board approves the investment in the new superliner.
2. Six-months ago Australian Galaxy Cruises paid TIA Consulting Group $250,000 to conduct initial analysis of the cash flows associated with the Pacific Dream superliner.
3. The purchase price of the new superliner, Pacific Dream, is $37 million. The purchase transaction will occur today and, as explained in paragraph 16, it will be partially funded with $7 million cash. To determine the tax-approved depreciation of Pacific Dream one needs to refer to the Australian Tax Office (ATO) Taxation Ruling TR2000/18 to determine the effective life. Superliners such as Pacific Dream are classified under the ‘Ships and steamers' category of ‘Water Transport' and therefore qualifies for an effective life of 20 years.
4. The sales team are quite excited with the new liner as it will increase the number of cruises that they can offer each year. Steven advises James that Pacific Dream has the capacity to operate 32 cruises a year. Based on 1,870 passengers and assuming standard pricing, Pacific Dream is forecasted to generate cash sales of $34.6 million each year. In order to ensure high occupancy levels when Pacific Dream is added to the fleet, Australian Galaxy Cruises will heavily promote the new vessel through an extensive $2.3 million annual marketing campaign in years 1 to 3. Steven tells James that to save money he must reduce the current total annual advertising budget of the existing cruises (Southern Dream and Eastern Dream) from $6.2 million to $5.5 million per year in years 1 to 3 only. The reduced advertising will not impact the sales of Southern Dream and Eastern Dream.
5. The initial euphoria generated by the promotion will allow Australian Galaxy Cruises to add a premium to the standard prices. The premium prices will mean total sales revenue for Pacific Dream of $37 million per year for years 1 to 4. For years 5 to 10, prices will revert to standard pricing levels and annual cash sales will revert to $34.6 million. All sales are by credit card with instant funds transfer to Australian Galaxy Cruises' bank account. Australian Galaxy Cruises' policy of not allowing credit sales means they will not have any accounts receivable, and consequently have zero defaults. James has enquired about the impact on sales of the existing Australian Galaxy Cruises fleet (Southern Dream and Eastern Dream) and the sales team respond that the impact on the two cruise liners is irrelevant. They state the only relevant sales figure to justify the Pacific Dream investment is the sales that the new superliner itself generates.
6. John Barnes is the firm accountant who works closely with James. John estimates employee costs directly associated with Pacific Dream assuming a crew size of 296. The industry standard salary in the cruise industry is $52,500 per year. John has indicated other annual operating costs include: $0.7 million insurance, $3.7 millionfood and beverages, and $0.59 million consumables. Australian Galaxy Cruises' headquarters overlooks Darling Harbour and Circular Quay. The personnel consist ofSteven, James, John, yourself, the sales team and the support staff. The total annual operating costs of headquarters is $1.95 million. This cost is equally allocated between Australian Galaxy Cruises? existing two cruise ships, Southern Dream and Eastern Dream. Steven wants to ensure that if Pacific Dream is purchased, then it also is allocated an equal share of the $1.95 million annual costs of operating the Australian Galaxy Cruises headquarters. The annual headquarters operating costs of $1.95 million are not expected to change with the introduction of Pacific Dream to the Australian Galaxy Cruises fleet.
7. Australian Galaxy Cruises? existing cruise liners (Southern Dream and Eastern Dream) berth at Wharf 7 Darling Harbour Passenger Terminal and total port charges payable to Sydney Ports are currently $1,777,000 per year. However, Pacific Dream is a large vessel that cannot be safely manoeuvred into Darling Harbour. Therefore, itcan only berth at the Overseas Passenger Terminal (OPT), Circular Quay. With the introduction of Pacific Dream to Australian Galaxy Cruises? fleet, annual port charges will increase to $2.44 million. The increased charges are due to the higher port charges at the OPT compared to Wharf 7. Restaurants (for example: Quay and ARIA) near the OPT experience a dramatic downturn in business when vessels berth therebecause customers? views of Sydney Harbour are blocked. Therefore, even though OPT port charges are high, Sydney Ports distributes $55,000 per annum of the port charges that it collects to each restaurant as compensation for the loss of trade.
8. Due to previous oil spills in Sydney Harbour, it is now mandatory that all vessels entering Sydney Harbour possess a Sydney Harbour spillage management plan and have a certificate to say they comply. This certificate provides verification that the vessel abides by strict safety standards. The certificate costs $1,156,000 and is valid for four years only and must be renewed at the end of every four years. If Australian Galaxy Cruises proceed with the Pacific Dream purchase, it is their responsibility as the new owners to pay for the first certificate that is required today. The cost of the certificate is a tax-recognised business expense when paid. The spillage management plan certificate cannot be separated from Pacific Dream and does not have a separate salvage value.
9. At the moment, James has determined that total fixed costs across the entire Australian Galaxy Cruises business are $8.41 million per year. These fixed costs are expected to remain at the same level with the introduction of Pacific Dream. These fixed costs exclude headquarter costs.
10. To operate Pacific Dream in Australian waters, it must be fitted with a bow thruster and a silent drive. The bow thruster ensures that the superliner can maneuverwithin the harbour without tugs, and the silent drive reduces the noise generated by the superliner?s twin propellers. To comply with Australian port authorities' regulation the $4.1 million bow thruster can only be fitted at an Australian shipyard. Once fitted, the bow thruster will last for twenty years. The Australian Tax Office (ATO) has provided a private ruling to Australian Galaxy Cruises declaring that the bow thruster is eligible for a 20% depreciation rate. Australian Galaxy Cruises purchased a spare silent drive five years ago for $3 million and at the time was provided a 25% depreciation rate by the ATO. Currently, the silent drive can be sold for $50,000 and will be worthless in 10 years? time. In addition, the driver has been written off for tax purposes.
11. In 10 years? time, Pacific Dream can be sold for $25 million to Champions League Voyages. The $25 million figure consists of $23.5 million value for the superliner itself, and $1.5 million value for the bow thruster. John reminds Steven that for management accounting purposes, the Board requires that Australian GalaxyCruises depreciates all assets over a ten year period.
12. John is aware that Steven has travelled around the world investigating different types of cruise liners before deciding on Pacific Dream. When Steven returned to the Sydney headquarters, John had to reconcile Steven's expenses. Australian Galaxy Cruises records show that $69,000 was paid to Steven as reimbursement for his travel expenses. These expenses have already been incurred so John recommends to James that the $69,000 amount be included as an opportunity cost and included as a start expense in the capital budgeting analysis.
13. Australian Galaxy Cruises policy is to have the world's youngest fleet so they plan to sell Pacific Dream after 10 years. By sticking to a strict four-year maintenance overhaul, Australian Galaxy Cruises ensures its fleet is kept in excellent condition which also maximises each line's salvage value. The maintenance overhaul will cost $5.22 million in year 4 and $3 million in year 8. The maintenance overhaul expenses are classified as an allowable tax deduction when paid. The overhaul means the cash sales in year four and year eight are reduced to only 75% of annual cash sales. Duringthe maintenance overhaul in year 4 and year 8, Pacific Dream's annual operating costs (with the exception of food and beverage) remain at the same level, regardless of whether it is removed from service for maintenance or not. Food and beverage costs are reduced to only 75% of annual food and beverage costs.
14. Pacific Dream will also require regular repairs such as daily cleaning of engine parts and minor cabin upkeep. These repairs do not require that Pacific Dream be removed from service. The total repairs expense is $2.09 million every year. To enable the maintenance to be carried out Pacific Dream also requires a large and extensive spare parts inventory that must be purchased today amounting to $1.67 million. Spare parts are used as required and the cost of purchasing replacement spare parts is included in the yearly repairs expense of $2.09 million.
15. Australian Galaxy Cruises' call centre that is based in rented premises in Adelaide will have to be expanded with the addition of Pacific Dream. The current annual call centre operating costs consist of $730,000 in rent and $690,000 in salary and wages. Steven has told James that if the call centre does expand, it must relocate to cheaper premises. John has negotiated with a property developer for a larger building on the outskirts of Adelaide that will suit the expanded call centre at an annual rental cost of $670,000. The salary and wages associated with the expanded call centre will increase to $892,000 per annum compared to the figure at the current call centre. The timing of rent payments for the Adelaide call centre occurs at the end of each year.
16. Pacific Dream's purchase price of $37 million will be funded by a combination of $7 million from Australian Galaxy Cruises existing cash and the remainder will represent debt. Steven informs James that the principal and interest repayments on the fully amortising secured loan are $3,330,000 per annum. John's amortisation schedule confirms that these repayments will ensure that the loan outstanding at the end of year ten is zero.
17. James states the required return for Pacific Dream is 12.4%. This discount rate is based on advice from their bankers. Steven is surprised that the discount rate is high but James explains the reason is due to the relative high level of systematic risk associated with the cruise liner industry.
18. During the project net income is projected to be:
|
Year
|
Net income
|
|
1
|
$6,037,500
|
|
2
|
$6,037,500
|
|
3
|
$6,037,500
|
|
4
|
$3,133,200
|
|
5
|
$5,477,500
|
|
6
|
$5,477,500
|
|
7
|
$5,477,500
|
|
8
|
$2,839,200
|
|
9
|
$5,477,500
|
|
10
|
$5,477,500
|
The information in paragraph 18 is to be used to calculate the accounting rate of return only.
19. The current value of Australian Galaxy Cruises is $10,987,654. The initial book value of Pacific Dream is $37 million. The tax rate is 30%. Tax is paid in the same year as a profit, or rebated in the same year as a loss.
Capital Budgeting Questions
Present an itemised breakdown (and the total) for each of the following:
1. The cash flows at the start.
2. The cash flows over the life.
3. The cash flows at the end.
4. What is the NPV of Pacific Dream?
5. What is the market value of Australian Galaxy Cruises if they invest in PacificDream?
6. What is the accounting rate of return (assuming the salvage value is equal to thebook value of the superliner in year 10)?
7. What is the payback period?
8. What is the profitability index?
9. What is the internal rate of return?
10. Would you recommend investing in Pacific Dream (restrict your answer to theblank cells provided)?