Summary
The objective of the report is to evaluate the financial viability of two projects that
the management team of Supersonic Australia is considering. The methodology of the
report is based on the analysis of discounted cash flow that each project is expected to
generate over its respective useful life. Based on the findings of the analysis, it is
recommended that the management team invest in the project with a longer useful life of
30 as this project is expected to generate a higher net present value and has a higher
internal rate of return. Nevertheless, where a larger amount of initial outlay is incurred
over a longer period of time, the management team may consider applying a higher
discount rate of reasonably reflect the underlying risk of the project.
Methodology
Regarding the methodology of the analysis, the financial metrics selected for
evaluation are the net present value, the internal rate of return and the profitability index.
Net present value refers to the total net cash flow that the project is expected to generate
for the entity overs its useful life (Keown, Martin & Petty, 2017), discounted back to a
reference point in time when the decision is considered, i.e. year 0 in this case, by
applying an appropriate discount rate. The discount rate is the minimum rate of return
that Supersonic Australia expects to receive in order to invest in any a particular project.
In another word, it is the opportunity cost incurred when the entity forgoes other projects
that its capital could have been invested in (Block, Hirt & Danielsen, 2019). Internal rate
of return is the rate of return, or a discount rate, that results in a project breaking even
over its useful life. In another word, it is the discount rate that results in a net present
value of zero for the project. Both net present value and internal rate of return are based
on the concept of discount cash flow, which has taken into account the time value of
money as $180M in year 0 is worth more than $180M in year 6 since this amount of capital
could be invested in projects in year 0 to generate additional returns in future periods.
Recommendations
For project 1 in which Supersonic Australia expects to operate a fleet of 6 jets over
a period of 20 years, the project is expected to generate a net present value of $57.6M
and has an internal rate of return of 20.60%. The minimum number of average
passengers per flight that is required for the project to be economically viable is 55.64.
For project 2 in which Supersonic Australia expected to operate the fleet for
additional 10 years by incurring an overhaul of the jets after 20 years, the project is
expected to generate a net present value of $71.4M and has an internal rate of return of
20.97%. The minimum number of average passengers per flight that is required for the
project to be economically viable is 54.84.
As far as these financial performance metrics are concerned, it is recommended
that the management team opts for project 2 with a longer useful life and an overhaul of
the jets after 20 years. This recommendation is based on the relatively higher net present
value and internal rate of return of project 2. In other word, the project with a useful life of
30 years is expected to generate a larger amount of return after adjusting for the time
value of money. On top of that, this project is expected to generate a rate of return that is
higher than the required rate of return of Supersonic Australia.
Regarding the minimum number of average passengers per flight, the metric is
calculated by finding the number of average passengers that results in the project
breaking even, i.e. having a net present value of zero.
Limitations
While the selected metrics have been justified in the analysis of the investment
projects that the management team of Supersonic Australia has at its disposal, there are
limitations to be taken into consideration. The introduction of a discount rate into the
calculation means that the management team ought to determine an appropriate cost of
capital to be used as the benchmark for investment appraisal. Companies with different
investment horizons and capital structure may opt for either cost of equity capital, cost of
debt capital or weighted average cost of capital (Block, Hirt & Danielsen, 2019).
Moreover, where the cash flow changes sign frequently between positive and negative
over the useful life of the project, there may be instances where the project may have
more than one internal rate of return (Keown, Martin & Petty, 2017), which may
complicate the decision-making process. Furthermore, the sole consideration of net
present value may not be appropriate as projects with more significant initial outlays or
longer useful lives tend to have a higher net present value. However, committing a larger
amount of capital or a similar amount of capital for a longer period of time may expose
the management team of Supersonic Australia to heightened risk, which should be offset
by a higher discount rate. In order to overcome this obstacle, the management team may
consider the profitability index, which compares the respective net present value of a
project to its initial outlay.
Reference
Keown, A., Martin, J. & Petty, J. (2017). Foundations of Finance. 9th edition. Pearson.
Block, S., Hirt, G. & Danielsen, B. (2019). Foundations of Financial Management. 17th
edition. McGraw-Hill.