Johnson Air plc is one of the UK’s most established and respected airlines. The company prides itself on its exceptional standard of service and has won awards for comfort and style. The company provides long-haul flights to destinations all over the world and in 2019 the company had a 17% share of an increasingly saturated long-haul market.
The company has ambitious growth plans and a recent strategic review has concluded that a new subsidiary, Flynow plc, should be established on July 1st 2020 to compete in the rapidly growing but highly competitive low-cost European short-haul market. The company believes it has the knowledge, expertise, capabilities and experience needed to develop a viable alternative offering in the “no-frills” market.
An order has been placed for three ER320 aircraft. Each plane has a capacity of 250 passengers in a single aisle format. Whilst buying new aircraft is expensive, in the long-run costs are lower after recent advances in fuel efficiency and reliability. A discount of twelve per cent on the list price of £70 million per aircraft was negotiated by Andrew Smith Johnson’s experienced Commercial Director. Past experience suggests the planes will recover ten per cent of their discounted cost when they are sold at the end of ten years. Johnson depreciate its aircraft on a straight-line basis over expected useful life. The company has also signed a maintenance service agreement with the manufacturer for £9.5 million per annum for all three aircraft.
Flynow will fly to smaller, secondary airports which have lower landing charges. A limited number of flights will be available to the most popular airports but these will take place during off-peak hours. Landing fees are expected to average £3 per passenger. After placing hedging contracts for the anticipated annual fuel requirements, fuel will cost £1,700 per hour.
A simple fare scheme will charge one-way tickets at half the amount of return trips. However, pricing is dynamic and based on demand. Discounts levels continually decrease as occupancy increases, rewarding early reservations. Thirty percent of seats are offered at the lowest price of £30 and are the first to sell. The prices steadily rise by 10% increments i.e. the next 10 seats are sold for £33 per head. This pattern will increase until the plane reaches the average occupancy level, which is expected to be 80%.
The low-cost European short-haul market is a highly competitive market and it is expected that prices will remain at the same level for the first 5 years. At the beginning of year 6, it isforecast that prices will increase by 10% and remain static for the remainder of the life of the aircraft. Discount levels will remain the same throughout the entire life of the aircraft.
The company will operate each aircraft for an average of 18 hours per day, 365 days per year. The remaining average 6 hours per day will be used for maintenance and ground crew activities. The flight time to all five of the initial destinations is very similar, at 1.4 hours. To make up for revenue lost in decreased ticket prices, the airline intends to charge for extras, such as priority boarding, allocated seating and additional baggage, which are expected to add a further 20% to each ticket price, both before and after the price rise in year 6.
Flynow will “hire” flight attendants and pilots from Johnson rather than recruit new staff who would need training. Pilots will be charged out at £250 each per flight and two are needed for each flight. Flight attendants are charged at £50 each per flight and regulations require one flight attendant per 50 passengers. These charge out rates will last for 5 years. Thereafter, flight attendant and pilot costs will increase by 5% for the remaining life of the aircraft.
Seventy ground crew, have been permanently recruited by Flynow, on average basic salaries of £30,000 with performance related pay expected to be a further 10% on basic salary. The company hopes to disembark passengers, service the aircraft and board passengers efficiently as quick turnaround allows maximum utilization of the aircraft and more flights per day. Ground crew average basic salaries are expected to rise at an annual rate of 1.5% for the next ten years.
A website has been launched advertising the company’s routes and fares. It is anticipated that 90% of the company’s business will be online. Online check-in is encouraged and automated check in machines are available at the airport. Sales, distribution and administrative costs are fixed at £4.6 million per year.
To fund the new venture, Johnson Air plc will issue 100m £1 shares in the new company and also take out a loan for the remaining funds needed to purchase the three new aircraft. The loan will have an annual fixed interest rate of 8%. Interest will be paid quarterly with the first payment starting on 31st September 2020. It is expected that, as a new venture, Flynow will be able to take advantage of a government scheme whereby no tax needs to be paid for the first 3 years.
The senior management team of Johnson Air plc recognise that their investment in Flynow is high risk, especially in such a competitive market, and have calculated the overall cost of capital for the investment to be 12%.
Question: Prepare a schedule of financial figures to used in the investment appraisal. This will be marked using correct figures only for each item.