Accounting for Performance and Control
King Airlines
King Airlines is one of many low-cost airlines in Europe. The managers want to expand the business and have an opportunity to purchase a plane to open a new route from London to Greece. The success of the company is dependent on achieving high load factors (the percentage of seats sold).
Data from management accontant
The plane will make 8 return trips every week with flights scheduled for 47 weeks. The average selling price for a return ticket is £170.00 and ticket prices will increase by a minimum of 4% per annum.
A forecast of the expected number of passengers per trip was prepared by the marketing department. The management accountant believes this forecast is similar to previous forecasts and is too optimistic.
The company considers different scenarios for the number of passengers and then calculates a weighted average number of passengers. Managers have used this approach to forecasting many times before.
Year 1
|
Load |
Seats |
|
Maximum number of seats |
200 |
|
Weighted average number of seats sold |
185 |
Years 2-5 (assume the plane will be in service for 5 years)
|
Load |
Seats |
|
Maximum number of seats |
200 |
|
Weighted average number of seats sold |
170 |
The number of passengers is expected to be slightly lower in years 1-5.
Investment
The plane will cost £10,000,000 and in 5 years its estimated value is £2,500,000.
Fuel Costs
King Airlines has decided to pool resources to purchase fuel in bulk through alliances with other airlines. All fuel is paid for in dollars.
The annual cost of the fuel is forecast at $5,000,000
The current exchange rate is $1.50 / £1 (1GBP = 1.5USD)
The forecast exchange rate is:
|
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
1.540 |
1.560 |
1.580 |
1.620 |
Fuel costs are very volatile. The managers agree that it would be sensible to estimate fuel cost inflation at 5% per annum.
Other costs
Variable costs are estimated at £3,200,000 per annum. These costs are expected to increase by 5% per annum.
Relevant fixed costs are forecast at £2,000,000 per annum. Management expect this cost to remain unchanged.
Tax
There are a number of capital allowances available for the company. For years 1 to 5 the accountants estimate that 10% of net cash flow will be payable in tax. Net cash flow is defined as sales less cash operating cost. Cash operating cost includes variable and fixed costs. There is a 12 month time lag for tax payments or refunds.
There will be a general election in the near future and there is a concern that the tax rate will increase to 15%. King Airlines can only wait and see if the tax rate changes.
Cost of capital
The weighted average cost of capital for new investments has been set at 12%. The 12% is a hurdle rate and the calculated weighted average cost of capital is approximately 9%.
Required
You are required to advise whether or not the company should invest in this project. You must have a clear recommendation for the company and you must justify your answer. Brief conclusions without any supporting analysis and discussion will not be considered a pass.
Assessment criteria
Report
Critically discuss the output from your model – this will be in the form of a report containing approximately 1,000 -1,250 words.
The report should focus on the sensitivity analysis. Assume that the other managers have limited financial knowledge and that you are the expert providing advice. A good report will give managers good advice. You are NOT required to identify any non-financial factors that may be relevant.
Your report will have two headings, Sensitivity Analysis and Conclusions based on Sensitivity Analysis. Consider this as your contribution to a more general report. Other managers will provide a discussion of the competition, suppliers, strategy and overall conclusions.
There is no need to write an introduction as you can assume all managers are familiar with the investment. Your contribution is to complete the model and sensitivity analysis.
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