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) Using the financial calculations in Microsoft Excel, the IRR is 22%.
2.What is the project’s NPV? (15 pts) Using our formula and double checked with Microsoft Excel, NPV = (1,100,000/1.15) + (1,450,000/1.15)^2 + (1,300,000/1.15)^3 + (950,000/1.15) ^ 4 – 3,000,000 = $450,866.74
3.Should the company accept this project and why (or why not)? (5 pts) The company should accept this project because its net present value is greater than zero.
4.Explain how depreciation will affect the present value of the project. (10 pts) Depreciation is not considered a cash flow, but it does generally reduce a company’s tax liability. Reducing a company’s tax liability would cause an increase in the present value of the project.
5.Provide examples of at least one of the following as it relates to the project: (5 pts each) a.Sunk Cost: AirJet hiring a consulting group to come in and evaluate the utility and feasibility of acquiring a new machine. Even if AirJet does not get the new machine, this money has already been spent and cannot be recovered. b.Opportunity cost: The cost of investing in a machine that could produce parts faster. The decision was to get a new machine to increase production of a component. The opportunity cost would be the cost of the next best alternative, which in this case is a machine that could produce parts faster or produce a component different from the one selected. c.Erosion: Erosion occurs when the cash flows of a new project come at the expense of a company’s existing projects/products. The goal of this project is to increase production of a special component. Increased production of this component could undercut the profits and cash flows of other components being made by AirJet.
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) 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 Raytheon, Boeing, Lockheed Martin, and the Northrop Grumman Corporation.
a.What is the YTM of the competitor’s bond? You may use a number of sources, but we recommend Morningstar. Find the YTM of one 15 or 20 year bond with the highest possible creditworthiness. You may assume that new bonds issued by AirJet Best Parts, Inc. are of similar risk and will require the same return. (5 pts) Boeing: 5.66%
b.What is the after-tax cost of debt if the tax rate is 34%? (5 pts) Cost of debt * (1-t) = 5.66% * (1-34%) = (5.66% - 1.9244%) = 3.7356%
c.Explain what other methods you could have used to find the cost of debt for AirJet Best Parts...