Digger Exploration Inc., a regional oil and gas company, is headquartered in Butte, America. The Company operates properties in Montana, North Dakota, Wyoming, and Colorado. The Company’s current travel policy requires employees to fly economy on scheduled commercial airline flights. The Company has grown significantly over the past two years and the number of employees complaining about the limited air service out of Butte has also grown significantly. The Company had hired a full-time travel manager to oversee all the corporate travel. In addition, the Company invested $300,000 last year in a travel hardware and software scheduling system but it now appeared that this system was not able to keep up with the required scheduling. In addition, it was forecasted that the number of required employee trips would increase at a rate of approximately 7 percent per year (the number of forecasted future round trips is presented in Table 2). Bert Todd, the Company’s CEO, came to conclusion that the employees may be wasting too much time sitting in area airports and has asked for your help in a formal assessment to determine if a permanent chance in the Company’s travel policy was warranted. You reviewed several different options over the course of the next month and identified three leading candidates that you would present to the CEO. 

1. Contracting time on commercial carriers. This option would require the smallest change from the current corporate travel policy. Employees would continue to fly economy on scheduled commercial flights, but the flights would be under a series of annually renewable contracts with a domestic airline. Under this option, the average ticket price would be $950 with the possibility of an up-grade to a first-class ticket for an additional $250. These tickets would be eligible for frequent flyer discounts (as noted in Table 1) however ticket prices under this option would be subject to annual price increases. There were several limitations under this option. Employees would be required to make reservations at least three days in advance of travel. This option would require the continued employment of the existing travel manager. All connections under this option would be required to be on the same carrier. It was estimated that his final limitation would lead to an average delay of four hours for every round-trip flight for each employee flying as they waited for their connecting flights. Given the number of limitations, and the likelihood of annual ticket price increases, this first alternative was considered to be the riskiest solution to the Company’s travel issue. 

2. The purchase of a private aircraft. Under the second alternative, the Company could purchase a used corporate jet for $2.1 million. The jet being considered has a range of 1,600 miles on a full tank of fuel which would easily reach any of the Company’s facilities. The plane is estimated to have a ten-year useful life and would be depreciated on a straight-line basis with an estimated salvage value of $800,000 that would be received upon the sale of the aircraft at the end of the ten years. This option would require the Company to incur additional costs related to a flight crew and the required maintenance of the aircraft (information related to these costs is presented in Table 1). It is estimated that these required costs would be subject to annual price increases as listed in Table 1. The advantages of acquiring a plane would include the virtual elimination of the waiting time by the employees. The outright acquisition would also allow the Company to avoid any price increases related to the rising prices of aircraft over the next ten years. The best aspect of owning a plane would be that it would be available on a “moment’s notice” and the Company would no longer need the services of a separate travel manager to coordinate travel plans. Due to these advantages, this option was considered to be the option with the lowest risk. 

3. Corporate aircraft time sharing. The final option would have the Company acquire a 25 percent ownership interest in a corporate jet for $750,000 from a private firm specializing in aircraft time-shared use to corporate clients. Under this option Digger would share ownership of the jet and would have exclusive use of the jet with just two hours of advance notice. The Company would be charged $1,100 per hour of flight time for direct operating expenses and would be charged a fixed fee of $75,000 for each year of the time-share contract. Under the conditions of the contract, these amounts would remain constant over the life of the five-year contract but could be increased (at the annual rate in Table 1) if the contract were renewed in year 6. The Company would be considered a part owner and as such they would be allowed to depreciate their $750,000 price over the five-year live life of the time share contract with an estimated $150,000 salvage value. At the end of the contract the lessor would repurchase the plane at its book (salvage) value and offer Digger Exploration a new five-year agreement with a new plane. It is likely that the price of a new plane would be subject to the price increases related to the cost of the plane as well as related increases in the fixed and variable operating expenditures (see Table 1). The estimated salvage value of any new plane would also be $150,000. There was an additional risk with option three in that the private firm lessor was a relatively new firm with not much of an industry track record. As a result, Digger considered the risk related to this option to be higher than the option to purchase a plane (Option 2) but less than the option to contract with a commercial carrier (Option 1). Table 1 Digger Exploration Corporate Travel Information 

1. Executive Travel Summary Average round trip flights per year (past three years) 50 Average time lost awaiting flight departures (hours per round trip flight) 4 Average airtime per round-trip flight (hours) 4 Average number of employees traveling per trip 4 

2. Commercial Airline Cost Data Average ticket price (round trip, economy) $ 950 Average frequent flier discount available to coach passengers $ 150 Average ticket price (round trip, first class) $ 1,250 Average frequent flier discount available to first-class passengers $ 200 

3. Internal Travel Cost Data Salary of travel manager (annual) $ 45,000 Average salary of employees (annual, including benefits) $ 208,000 

4. Jet Aircraft Ownership Costs Acquisition cost $ 2,100,000 Range (miles) 1,600 Passenger seating capacity (excluding crew) 7 Direct operating cost (per hour of flight) Fuel $ 400 Crew $ 250 Maintenance $ 125 Total direct operating costs per hour of flight $ 775 Annual fixed costs $ 105,000 

5. Projected Annual Price Increases for Travel-Related Expenditures Salaries Travel manager (all office personnel) 3.0% Flight crew 4.0% Executive travelers 6.0% Commercial air fares Economy tickets 3.0% First-class tickets 3.0% Capital expenditures Jet aircraft prices 3.00% Fuel costs 4.00% Maintenance costs 4.00% Fixed expenses 4.00% Direct operating expenses 3.00% 

6. Risk-Adjusted Hurdle Rates and Corporate Income Tax Rate Low-risk hurdle rate (cost of capital) 10.0% Average-risk hurdle rate (cost of capital) 14.0% High-risk hurdle rate (cost of capital) 18.0% Corporate income tax rate 21.0% Table 2 Forecast of the Number of Round Trip Flights Over the Next Decade Year 1 53 Year 2 57 Year 3 61 Year 4 65 Year 5 70 Year 6 75 Year 7 80 Year 8 85 Year 9 92 Year 10 98 

Required: 

1. Each of the three alternatives covers a different length of time (one year, five years, or ten years). What is the appropriate period of time to compare these three options in your analysis to select the best option? 

2. Is there a value associated with the time employees currently spend waiting for connecting flights? If so, what is the value associated with an average flight (four employees with a wait time of 4 hours). Assume employees work 40 hours per week or 2,080 hours annually. 

3. Prepare a schedule of after-tax cash flows for each of the three options over the period of time you identified in requirement 1. 

4. Calculate a risk adjusted net present value (NPV) based on the hurdle rates identified in Table 1. (hint: you are dealing with cash outflows only so be careful with your assignment of the appropriate hurdle rate for each option). 

5. Which of the three options would you recommend to Mr. Todd? Are there any other factors that should be considered in your decision other than NPV?

Answer rating: 100% (QA)

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