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

Year 2$1,450,000

Year 3$1,300,000

Year 4$950,000

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)

Using this online IRR Calculation Tool http://finance.thinkanddone.com/online-i… we get the following IRR

Discounted Net Cash Flows at 19%

DCF1 = 1100000/(1+19%)^1 = 1100000/1.19 = 924369.75

DCF2 = 1450000/(1+19%)^2 = 1450000/1.4161 = 1023938.99

DCF3 = 1300000/(1+19%)^3 = 1300000/1.68516 = 771440.56

DCF4 = 950000/(1+19%)^4 = 950000/2.00534 = 473735.31

NPV Calculation at 19%

NPV = 924369.75 + 1023938.99 + 771440.56 + 473735.31 -3000000 NPV = 3193484.61 -3000000

NPV at 19% = 193484.61

Discounted Net Cash Flows at 24%

DCF1 = 1100000/(1+24%)1 = 1100000/1.24 = 887096.77

DCF2 = 1450000/(1+24%)2 = 1450000/1.5376 = 943028.1

DCF3 = 1300000/(1+24%)3 = 1300000/1.90662 = 681833.44

DCF4 = 950000/(1+24%)4 = 950000/2.36421 = 401824.92

NPV Calculation at 24%

NPV = 887096.77 + 943028.1 + 681833.44 + 401824.92 -3000000

NPV = 2913783.23 -3000000

NPV at 24% = -86216.77

IRR with Linear Interpolation

iL = 19%

iU = 24%

npvL = 193484.61

npvU = -86216.77

IRR = iL + [(iU-iL)(npvL)] / [npvL-npvU]

IRR = 0.19 + [(0.24-0.19)(193484.61)] / [193484.61--86216.77] IRR = 0.19 + [(0.05)(193484.61)] / [279701.38]

IRR = 0.19 + 9674.2305 / 279701.38

IRR = 0.19 + 0.0346

IRR = 0.2246

IRR = 22.46%

2.What is the project’s NPV? (15 pts)

Using this online NPV Calculation Tool http://finance.thinkanddone.com/online-n… we get the following NPV at 15%

Net Cash Flows

CF0 = -3000000

CF1 = 1100000

CF2 = 1450000

CF3 = 1300000

CF4 = 950000

Discounted Net Cash Flows

DCF1 = 1100000/(1+0.15)1 = 1100000/1.15 = 956521.74

DCF2 = 1450000/(1+0.15)2 = 1450000/1.3225 = 1096408.32

DCF3 = 1300000/(1+0.15)3 = 1300000/1.52087 = 854771.1

DCF4 = 950000/(1+0.15)4 = 950000/1.74901 = 543165.58

NPV Calculation

NPV = 956521.74 + 1096408.32 + 854771.1 + 543165.58 -3000000 NPV = 3450866.74 -3000000

NPV = $450,866.74

3.Should the company accept this project and why (or why not)? (5 pts) The company should accept this project since its IRR is higher than the required rate of return and it has a positive NPV.

http://finance.thinkanddone.com

http://mbastudyguide.weebly.com/

4.Explain how depreciation will affect the present value of the project. (10 pts)

While not recognized as a cash flow, depreciation would affect amount of tax paid on inflows from the project.

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

c.Erosion

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) Answers will vary, students should provide some examples related to forecasting risk or estimation errors on revenues or costs and erosion as project-specific, and changes in economic conditions (inflation, interest rates, political/legal risks) as well as new competitors as some market risks. 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 assist in the process of obtaining this rate. 1.Compute the cost of debt. Assume AirJet Best Parts Inc. is considering issuing new bonds. Select current bonds from one of the main competitors as a benchmark. Key competitors include...