BUSINESS FINANCING OF PHOENIX SOUTHERN LINES

QUESTION

25300 Fundamentals of Business Finance
Spring Semester 2011
Case Study

Due by 9am on Monday 17
th
October 2011
(Answers to be submitted using the Assignments feature of UTSOnline)

Contributes 15% of your assessment marks
Phoenix Southern Lines new liner

1. Marsellus Wallace, the Chief Executive Officer (CEO) of Phoenix Southern Lines
is very excited about the preliminary financial analysis that the company has
performed in relation to purchasing a new superliner to be named Southern
Constellation for Phoenix Southern Lines. Now, Marsellus is eager to proceed to a
capital budgeting analysis which involves an estimation of the future cash flows of the
new superliner, Southern Constellation. Marsellus would like Mia Wallace the CFO
to make a recommendation to the Board of Directors regarding the proposed Southern
Constellation investment. Mia is well aware that her recommendation will be
ultimately based on the Net Present Value.

2. Mia has asked Butch Coolidge and Jules Winnfield to investigate the relevant cash
flows associated with the superliner who did the initial report for Marsellus which
cost Phoenix Southern Lines $250,000. Butch and Jules have collected a large amount
of information but Mia is concerned that they are both still thinking in terms of
accounting figures so she is a little cautious about accepting their figures as cash flow.
Given Mia‟s experience, she has had a brief look at the figures and has already
identified some errors.

3. The purchase price of the new superliner, Southern Constellation, is $44 million.
The purchase transaction will occur today and, as explained in paragraph 16, it will be
partially funded with $4 million cash. To determine the tax-approved depreciation of
Southern Constellation first refers to the Australian Tax Office (ATO) Taxation
Ruling TR2000/18 to determine the effective life. Superliners such as Southern
Constellation are classified under the „Ships and steamers‟ category of „Water
Transport‟ and therefore qualifies for an effective life of 20 years.

4. Jules and Butch have been discussing with the sales department the anticipated
annual sales figure. The sales team are quite excited with the new liner as it will
increase the number of cruises that they can offer each year. Marsellus advises Mia
that Southern Constellation has the capacity to operate 39 cruises a year. Based on
1,450 passengers and assuming standard pricing, Southern Constellation  is forecasted
to generate cash sales of $31.5 million each year. In order to ensure high occupancy
levels, when Southern Constellation is added to the fleet Phoenix Southern Lines will
heavily promote the new vessel through an extensive $2.3 million annual marketing
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campaign in years 1 to 4. The $2.3 million annual Southern Constellation marketing
campaign in years 1 to 4 is a tax deduction when paid. Marsellus tells Mia that to save
money she must reduce the current annual advertising budget of Southern Sun and
Sothern Star from $6.2 million to $4.2 million per year in years 1 to 4 only. The
reduced advertising will not impact the sales of Sothern Sun and Southern Star.

5.The initial euphoria generated by the promotion will allow Phoenix Southern Lines
to add a premium to the standard prices. The premium prices will mean total sales
revenue for Southern Constellation of $39 million per year for years 1 to 4. From year
5, prices will revert to standard pricing levels and annual cash sales will revert to
$31.5 million. All sales are by credit card with instant funds transfer to Phoenix
Southern Lines‟ bank account. Phoenix Southern Lines‟ policy of not allowing credit
sales means they will not have any accounts receivable, and consequently have zero
defaults. Jules asks about the impact on sales of the existing Phoenix Southern Lines
fleet (Southern Sun and Southern Star) and the sales team respond that the impact on
the two cruise liners is irrelevant. They state the only relevant sales figure to justify
the Southern Constellation investment is the sales that the new superliner itself
generates.

6. Butch has estimated the employee costs directly associated with Southern
Constellation assuming a crew size of 340. Butch also has assumed an average annual
salary cost of $46,000 which is the accepted standard in the cruise industry. Butch has
indicated other annual operating costs include $0.5 million insurance, $3.9 million
food and beverages, and $0.65 million consumables. Phoenix Southern Lines‟
headquarters overlooks Darling Harbour and Circular Quay. The personnel consist of
Marsellus, Mia, Butch and Jules and several support staff. The total annual operating
costs of headquarters is $2.38 million. This cost is equally allocated between Phoenix
Southern Lines‟ existing two liners, Southern Sun and Southern Star. Marsellus wants
to ensure that if Southern Constellation is purchased, then it also is allocated an equal
share of the $2.38 million annual costs of operating the Phoenix Southern Lines
headquarters.

7. Phoenix Southern Lines‟ existing cruise liners (Southern Sun and Southern Star)
berth at Wharf 8 Darling Harbour Passenger Terminal and total port charges payable
to Sydney Ports are currently $1,968,000 per year. However, Southern Constellation
is a large vessel that cannot be safely manoeuvred into Darling Harbour. Therefore, it
can only berth at the Overseas Passenger Terminal (OPT), Circular Quay. With the
introduction of Southern Constellation to Phoenix Southern Lines‟ fleet, annual port
charges will increase to $2.9 million. The increased charges are due to the higher port
charges at the OPT compared to Wharf 8. Restaurants at OPT experience a dramatic
downturn in business when vessels berth there because customers‟ views of Sydney
Harbour are blocked. Therefore, even though OPT port charges are high, Sydney
Ports distributes $70,000pa of the port charges that it collects to each restaurant as
compensation for the loss of trade.

8. Due to previous oil spills in Sydney Harbour, it is now mandatory that all vessels
entering Sydney Harbour possess a Sydney Harbour spillage management plan and
have a certificate to say they comply. This certificate provides verification that the
vessel abides by strict safety standards. The certificate costs $934,000 and is valid for
four years only and must be renewed every four years. If Phoenix Southern Lines
2
proceed with the Southern Constellation purchase, it is their responsibility as the new
owners to pay for the first certificate that is required today. The cost of the certificate
is a tax-recognised business expense in the year paid. Because the certificate is valid
for four years, Jules recommends that one-fourth of the $934,000 cost be allocated as
an expense each year.

9. At the moment, Mia has determined that total fixed costs across the entire Phoenix
Southern Liners business are $14.2 million per year. These fixed costs are expected to
remain at the same level with the introduction of Southern Constellation.

10. To operate Southern Constellation in Australian waters, it must be fitted with a
bow thruster. This ensures that the superliner can manoeuvre within the harbour
without tugs. To comply with Australian port authorities regulation the $3 million
bow thruster can only be fitted at an Australian shipyard. Once fitted, the bow thruster
will last for twenty years. The Australian Tax Office has provided a private ruling to
Phoenix Southern Lines declaring that the bow thruster is eligible for a 20%
depreciation rate.

11. In 10 years‟ time, Southern Constellation can be sold for $25 million to a
European cruise company. The $25 million figure consists of $23 million value for
the superliner itself, and $2 million value for the bow thruster. Butch reminds
Marsellus that for management accounting purposes, the Board requires that Phoenix
Southern Lines depreciates all assets at 10% per annum.

12. Butch is aware that Marsellus has travelled around the world investigating
different types of cruise liners before deciding on Southern Constellation . When
Marsellus returned to the Sydney headquarters, Butch had to reconcile Marsellus‟
expenses. Phoenix Southern Lines‟s records show that $210,000 was paid to
Marsellus as reimbursement for his travel expenses. These expenses have already
been incurred so Butch recommends to Mia the $210,000 amount be included as an
opportunity cost and ignored from the capital budgeting analysis.

13. Phoenix Southern Lines‟s policy is to have the world‟s youngest fleet so they plan
to sell Southern Constellation after 10 years. By sticking to a strict four-year
maintenance overhaul, Phoenix Southern Lines ensures its fleet is kept in excellent
condition which also maximises each liner‟s salvage value. In year 4 and year 8
Phoenix Southern Lines will remove Southern Constellation from service for a 3month
maintenance
overhaul
that
costs
$4
million.
The
overhaul
means
the
cash
sales

in

year four and year eight are reduced to only 75% of annual cash sales. Southern
Constellation‟s annual operating costs (with the exception of food and beverage)
remain at the same level, regardless of whether it is removed from service for
maintenance or not. Food and beverage costs are not incurred for each of the two 3month
maintenance
overhaul
periods.

14.

Southern Constellation will also require regular repairs such as daily cleaning of
engine parts and minor cabin upkeep. These repairs do not require that Southern
Constellation be removed from service. The total repairs expense is $2 million every
year. To enable the maintenance to be carried out Southern Constellation also requires
a large and extensive spare parts inventory that must be purchased today amounting to
3
$1.9 million. Spare parts are used as required and the cost of purchasing replacement
spare parts is included in the yearly repairs expense of $2 million.

15. Phoenix Southern Lines‟ call centre that is based in rented premises in Melbourne
and will not have to be expanded with the addition of Southern Constellation to the
Phoenix Southern Lines fleet as there is spare capacity. The current annual call centre
operating costs consist of $830,000 in rent and $790,000 in salary and wages.

16. Southern Constellation‟s purchase price of $44 million will be funded by a
combination of $4 million from Phoenix Southern Lines‟s existing cash and the
remainder will represent debt. Marsellus informs Mia that the principal and interest
repayments on the fully amortising secured loan are $5,441,006pa. Butch‟s
amortisation schedule confirms that these repayments will ensure that the loan
outstanding at the end of year ten is zero.

17. Mia states the required return for Southern Constellation  is 11.7%. This discount
rate is based on advice from their bankers. Marsellus is surprised that the discount rate
is high but Mia explains the reason is due to cruise liner industry relatively high
quantity of systematic risk.

Notes:

1. The spillage management plan certificate cannot be separated from Southern
Constellation and does not have a separate salvage value.
2. The $4 million maintenance overhaul is classified as an allowable tax deduction
when paid.
3. The annual headquarters operating costs of $2.38 million are not expected to
change with the introduction of Southern Constellation to the Phoenix Southern Lines
fleet.
4. The tax rate is 30%. Tax is paid in the same year as a profit, or rebated in the same
year as a loss.
4
Instructions
Your team is required to answer and to conduct a capital budgeting analysis of the
proposed new superliner for Phoenix Southern Lines. You must determine:

1. The cash flows at the start
2. The cash flows over the life
3. The cash flows at the end
4. The appropriate discount rate
5. The NPV of the project
6. A brief recommendation (no more than 10 words)

Enter your answers into the EXCEL spreadsheet provided under “Assignments”. This
spreadsheet is designed especially so that the answers to the six questions will fit on
one A4 page which speeds up the marking process and enables faster feeedback. The
spreadsheet is protected which means that only a restricted number of cells can be
used. The cells that you cannot use are coloured grey.

Right click on the link “case_study.xls” and choose “Save Target As…”.
Open the spreadsheet and enter each team member‟s details and the tutorials details of
one team member. Marked spreadsheets will be returned in the nominated tutorial
only.

Enter your information to the six questions in the vacant white cells. For Q1, 2 and 3,
enter the cash flow description and the dollar amount in the appropriate cells. Use
whole dollars only – ignore cents. There are more rows than required, so if you‟ve
used all the rows then it means you‟ve got too many cash flow items. Q4, 5 and 6 can
be answered using the single row provided. Don‟t worry if any of your numbers
appear as “######” because we can view it.

It is your team‟s task as future financial managers to sort through the information and
correctly identify the cash flows to be sued in capital budgetting. For this reason, we
will not provide direct “yes/no” answers to your UTSOnline questions. We will of
course clarify perceived ambiguities.

We will not answer questions by email (email is acceptable only for questions of a
private/personal nature). Questions belong on UTSOnline because everyone benefits
from your question and the answer (whether the answer is given by us or another
student)

Any one team member can lodge the case study however it is each team member‟s
responsibility to ensure the case study has been correctly lodged.

Everyone in a team gets the team‟s mark so ensure your team members contribute
equally. As per the subject outline case study‟s submitted with less than three team
members will not be marked.

SOLUTION

GG09

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