Air South, a leading regional airline that is now carrying 54% of all the passengers that pass through the Southeast, is considering adding a new long range aircraft to its fleet. The aircraft being considered for purchase is the McDonnell Douglas DC 9 532 “Funjet,” which is quoted at $60 million per unit. McDonnell Douglas requires a 10% down payment at the time of delivery, and the balance is to be paid over a 10 year period at an interest rate of 12% compounded annually. The actual payment schedule calls for only interest payments over the 10 year period, with the original principal amount to be paid off at the end of the 10th year. Air South expects to generate $35 million per year by adding this aircraft to its current fleet, but also estimates an operating and maintenance cost of $20 million per year. The aircraft is expected to have a 15 year service life with a salvage value of 15% of the original purchase price. If the aircraft is bought, it will be depreciated by the 7 year MACRS property classifications. The firm’s combined federal and state marginal tax rate is 38%, and its required minimum attractive rate of return is 18%.
(a) Use the generalized cash flow approach to determine the cash flow associated with the debt financing.
(b) Is this project acceptable?