JetBlue has had a great deal of success flying their new Airbus 321 Transcontinental from JFK to LAX and SFO. They are now considering adding this service from BOS-SFO by putting 2 new Airbus 321T's into service.

http://www.seatguru.com/airlines/JetBlue_Airways/Jetblue_Airways_Airbus_A321_transcon.php

The plane flies 4 classes of service with an average price indicated

• Coach - $280/one way
• Coach - Even More Space - $360/one way
• Business (Mint) $800/one way
• Private Suite (Mint Suit) $1,050/one way

A feasibility study of transcontinental transportation was conducted 3 months ago by JetBlue for $500,000. While the list price of a new plane is $180 Million, negotiating prices are typically 40% less. Net working capital requirements are expected to increase $7 Million at the kickoff of the project. The planes are depreciated over 12 years, straight-line. JetBlue, in order to keep their fleet fresh, expects to sell the planes after 10 years for salvage value.

The new plane will require ground investment as well including the addition of a gate at SFO and BOS. Luckily for JetBlue, they already have a spare gate at each airport valued at $750,000 each (which they could have sold to another airline).

JetBlue expects that the planes will fly 80% full during the first year in coach and Even More Space seats while Mint Seats should fly at 70% occupancy. Each plane will be able to fly 3 one way legs per day and fly 28 days per month (2 days down for maintenance).

Fixed costs are estimated at $16 Million with variable costs being 20% of revenue.

JetBlue is in 35% federal tax bracket and 5% state tax rate.

Questions:

A. Calculate the Year 0 Capital Investment.

B. Calculate the company's Income Statement for year 1

C. Calculate the company's Project Operating Cash Flow for Year 1

D. Assuming the company's Project Operating Cash Flow stays the same for 10 years, what would the NPV be for the project assuming a cost of capital of 9% with the plane sold for salvage value in year 10.

E. Turns out, JetBlue can get $45 Million for the plane in year 10. Calculate the aftertax cash flow from the sale of the plane at that time.

Questions

1. Explain why a company's optimal structure contains a mix of debt and equity. If one is cheaper than the other, than why not all equity? Why not all debt?

Use the following to answer the next two questions:

You are setting up a new retail store. The average purchase is $42. Fixed costs are $15,000 per month while variable costs are 40%. Depreciation is $1,000 per month.

2. Calculate total sales needed to reach breakeven on a monthly basis on a cash flow and accounting basis.

3. Assume 1,000 customers come through the doors in the first month. What is the degree of operating leverage at that sales level? Test your answer by increasing or decreasing sales 10%.

HAC Corporation has 10 million shares of common stock outstanding, 700,000 shares of 6 percent preferred stock outstanding, and 200,000 6.8 percent semiannual bonds outstanding, par value $1,000 each. The common stock currently sells for $24 per share and has a beta of 0.75, the preferred stock currently sells for $94 per share, and the bonds have 12 years to maturity and sell for 107 percent of par. The market risk premium is 7.5 percent, T-bills are yielding 4 percent, and Titan Mining's tax rate is 40 percent.

4. What is the company's market value capital structure?

5. If HAC is evaluating a new investment project that has the same risk as the firm's typical project, what rate should the firm use to discount the project's cash flows?

Multiple Choice

1. Which one of the following states that the value of a firm is unrelated to the firm's capital structure?

A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis

2. Which one of the following states that a firm's cost of equity capital is directly and proportionally related to the firm's capital structure?

A. Capital Asset Pricing Model
B. M & M Proposition I
C. M & M Proposition II
D. Law of One Price
E. Efficient Markets Hypothesis

3. Butter & Jelly reduced its taxes last year by $350 by increasing its interest expense by $1,000. Which of the following terms is used to describe this tax savings?

A. interest tax shield
B. interest credit
C. financing shield
D. current tax yield
E. tax-loss interest

4. The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs.

A. Flotation
B. direct bankruptcy
C. indirect bankruptcy
D. financial solvency
E. capital structure

5. By definition, which of the following costs are included in the term "financial distress costs"?

I. direct bankruptcy costs
II. indirect bankruptcy costs
III. direct costs related to being financially distressed, but not bankrupt
IV. indirect costs related to being financially distressed, but not bankrupt

A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV.