Aardvark Air's Fleet Replacement Decision
Aardvark Air operates 12 regional aircraft with an average age of 14 years. It can (a) continue operating the fleet for 5 more years with annual maintenance rising from £8m to £14m and a residual value of £10m, or (b) replace now with 10 new aircraft costing £320m, depreciated straight-line to zero over 10 years, cutting fuel and maintenance costs by £22m pa and yielding a residual of £60m at year 10. The new fleet requires a £40m upfront training and certification cost. Aardvark's equity beta is 1.35, debt/equity is 40:60, the risk-free rate is 3.5%, the market return is 9%, pre-tax cost of debt is 5.5%, and tax is 25%. The project is in the same risk class as existing operations.
1. Compute the appropriate discount rate and evaluate the replacement using NPV over a consistent horizon.
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WACC. Unlever the equity beta: βu = 1.35 / [1 + (1−0.25)(40/60)] = 1.35 / 1.5 = 0.90. Re-lever at target D/E 40:60: βl = 0.90 × 1.5 = 1.35 (unchanged, so use 1.35).
Ke = 3.5% + 1.35 × (9% − 3.5%) = 3.5% + 7.425% = 10.93%. Kd after tax = 5.5% × 0.75 = 4.13%. Weights E 60%, D 40%.
WACC = 0.6 × 10.93% + 0.4 × 4.13% = 6.56% + 1.65% = 8.21%.
Horizon mismatch. Option (a) covers 5 years, option (b) 10 years. Use an equivalent annual annuity (EAA) comparison or extend (a) to a 10-year equivalent. Simplest: compare on a 10-year basis assuming (a) is repeated (maintenance costs continue rising).
Option (b) NPV. Outflows: £320m + £40m training = £360m at t0. Annual saving £22m for years 1–10. Tax: depreciation £32m pa gives tax shield £8m pa; savings taxed at 25% so net cash saving = 22 × 0.75 + 8 = £24.5m pa. Residual £60m at year 10 (assume no tax on residual for simplicity).
PV of £24.5m annuity, 10 yrs @ 8.21%: annuity factor = (1 − 1.0821⁻¹⁰)/0.0821 = (1 − 0.4546)/0.0821 = 6.643. PV = 24.5 × 6.643 = £162.8m. PV residual = 60 × 0.4546 = £27.3m. Total PV inflows = £190.1m. NPV = 190.1 − 360 = −£169.9m.
Option (a) NPV. Rising maintenance £8m→£14m (increment £1.2m pa), no capital outlay, residual £10m at year 5. Discounted over 5 years, the PV of maintenance costs is substantial but far smaller in absolute terms than £360m capex, and no £320m outflow.
Judgement. On these inputs, replacement is value-destructive unless the £22m saving is understated or the aircraft cost is financed off-balance-sheet. The model answer should flag that the £22m saving is too small relative to £320m capex; the case turns on whether savings persist for 10 years and whether residual/financing terms change the picture.
2. The board argues the discount rate should be the group WACC of 6.5% because 'aircraft are core.' Critique this and state the correct treatment.
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Critique. Using a group WACC of 6.5% for a specific fleet-replacement decision is wrong on two counts:
Risk-class mismatch. The group WACC reflects the average risk of all Aardvark's activities. If the new fleet has a different operating risk profile (new routes, different aircraft type, different demand elasticity), its cash flows should be discounted at a rate reflecting that project's systematic risk, not the group average. Using a lower rate than justified systematically overstates NPV and biases the decision toward acceptance.
Financing side-effects. The 6.5% figure may embed the group's existing capital structure. If the fleet is debt-financed with a different gearing, the WACC should be re-levered to the project's target gearing (as done here: 8.21%).
Correct treatment. Estimate a project-specific asset beta from comparable pure-play regional airlines, re-lever to the project's target D/E, and compute a project WACC. If no reliable comparable exists, use the group WACC only if the project is genuinely in the same risk class - which the question states it is - but then the correct group WACC is 8.21%, not 6.5%. The 6.5% figure appears to understate the cost of equity; at 6.5% the £24.5m annuity factor becomes 7.19, PV inflows £203m, NPV −£157m - still negative, so the decision is robust to the rate choice, but the reasoning must be corrected.