You will assume that you still work as a financial analyst for AirJet Best Parts, Inc. The company is considering a capital investment in a new machine and you are in charge of making a recommendation on the purchase based on (1) a given rate of return of 15% (Task 4) and (2) the firm’s cost of capital (Task 5). Task 4. Capital Budgeting for a New Machine
A few months have now passed and AirJet Best Parts, Inc. is considering the purchase on a new machine that will increase the production of a special component significantly. The anticipated cash flows for the project are as follows: Year 1$1,100,000
You have now been tasked with providing a recommendation for the project based on the results of a Net Present Value Analysis. Assuming that the required rate of return is 15% and the initial cost of the machine is $3,000,000. 1. What is the project’s IRR? (10 pts)
Irr=0.22446 or 22.46%
2. What is the project’s NPV? (15 pts)
3. Should the company accept this project and why (or why not)? (5 pts) Answer: Yes, I believe the company should accept this project. The company’s IRR is greater than the RRR and the NPV of $450,866.74 is a positive. Whenever the Irr is greater than the RRR or the NPV is zero or greater, the investment will earn a return greater than the RRR.
4. Explain how depreciation will affect the present value of the project. (10 pts) Answer: Present value is the current worth of a future stream of cash flows at a specific rate. The time value of money forms the basis of net present value method for evaluating capital investments/projects. These projects have both cash inflows and cash outflows. Depreciation does not directly affect cash flow, it indirectly affects cash flow because it reduces the amount of tax the company must pay. Depreciation is a tax shield. Therefore, the earlier AirJet can claim a depreciation deduction, the greater its present value will be.
5. Provide examples of at least one of the following as it relates to the project: (5 pts each) a. Sunk Cost
b. Opportunity cost
Answer:One example is for sunk cost. Sunk costs are past cost that have already been incurred and cannot be recovered. AirJet paid $3,000,000 for the machine the company assumed would increase the production of a special part. After using the machine to enhance production, AirJet later realized the machine, in fact, slows down the production rather than speed it up. This is sunk cost. AirJet cannot recover the money already spent.
6. Explain how you would conduct a scenario and sensitivity analysis of the project. What would be some project-specific risks and market risks related to this project? (20 pts) Answer: The first thing to be done when conducting a scenario and sensitivity analysis of the project is to compute the NPV for different scenarios such as cash flows, rate of return, and changes to the initial cost. After the NPV is calculated, the factor that reduces the NPV to values which are lower than zero, which will be negative values, should be incorporated to determine the factors that may be sensitive for the project.
Task 5: Cost of Capital
AirJet Best Parts Inc. is now considering that the appropriate discount rate for the new machine should be the cost of capital and would like to determine it. You will...