CourseProjectPartII

Introduction YouwillassumethatyoustillworkasafinancialanalystforAirJetBestParts,Inc.The companyisconsideringacapitalinvestmentinanewmachineandyouareinchargeofmakinga recommendationonthepurchasebasedon(1)agivenrateofreturnof15%(Task4)and(2)the firmscostofcapital(Task5). Task4.CapitalBudgetingforaNewMachine AfewmonthshavenowpassedandAirJetBestParts,Inc.isconsideringthepurchaseonanew machinethatwillincreasetheproductionofaspecialcomponentsignificantly.Theanticipated cashflowsfortheprojectareasfollows: Year1 Year2 Year3 Year4 $1,100,000 $1,450,000 $1,300,000 $950,000

Youhavenowbeentaskedwithprovidingarecommendationfortheprojectbasedontheresults ofaNetPresentValueAnalysis.Assumingthattherequiredrateofreturnis15%andtheinitial costofthemachineis$3,000,000.

Requiredrateofreturn Year 0 1 2 3 4 CashFlow $(3,000,000) $1,100,000 $1,450,000 $1,300,000 $950,000

15%

1. WhatistheprojectsIRR?(10pts)=22.38% 2. WhatistheprojectsNPV?(15pts)=$450,867.00

ComputationofNetPresentValue

Year 1 2 3 4

CashFlow $1,100,000 $1,450,000 $1,300,000 $950,000

PresentFactor Present @15% Value 0.8696 $956,522. 0.7561 $1,096,408. 0.6575 $854,771. 0.5718 $543,166. Total= $3,450,867. Less:Initialcost= $(3,000,000) NPV= $450,867.00

Formula: CashFlow x

PresentFactor@ 15%=

Present Value

1100000x0.869565217391304=956521.739130435 1450000x0.756143667296787=1096408.31758034 1300000x0.657516232431988=854771.102161585 950000x0.571753245593033=543165.583313382 Total=3450866.74218574 LessInitialCost=3000000

NPV=$450,867.00

3. Shouldthecompanyacceptthisprojectandwhy(orwhynot)?(5pts)Yes.

Inlookingattheoverallanalysisoftheproject,Ibelieveitwouldbe beneficialtoaccepttheprojectbecause,theprojects(IRR)Internal RateReturnisgreaterthanthe(RRR)RequiredRateofReturnandthe overall(NPV)NetPresentValueispositiveorgain.

4. Explainhowdepreciationwillaffectthepresentvalueoftheproject.(10pts)

Whenlookingatthedepreciationofthisproject,depreciationwouldcauseanincrease intheprojects(PV)PresentValue,duetothefactthat,itwould saveontheamountoftaxesandrealizestaxshield.

5. Provideexamplesofatleastoneofthefollowingasitrelatestotheproject:(5ptseach) a. SunkCostarecostthatarenonrecoverablebecausetheyhavealreadybeen

incurredandcannotberecovered.ExampleAirJetBestParts,Inc.paid$1 milliondollarupfrontforbuildingpermitsinordertosetuptheircompany.AirJet BestParts,Inc.isplanningtousethesepermitstoinstallastateoftheartgym,in orderallowemployeestomaintaintheirhealth,throughtheirrigorouswork schedule.Therefore,thecostforthesebuildingpermitsareconsideredasunk cost,duetothefactthat,theyareirrelevantintheanalysisofpurchaseofnew machinebecause,thesecostswerealreadytakenintoconsiderationand/or incurredandthereforeunaffectedifmachinesarepurchasedornot.

b. Opportunitycostcostthatareincurredwhengivingupanopportunityforfree.

Example:AirJetBestParts,Inc.marketsatestersoftwareforitscompanyand givesitawaytoanumberofotherbusinessesforfreebut,thesoftwareonlyhas limitedcapabilities.AirJetBestParts,Inc.advertisethefullversionataminimal

cost,andAirJetBestParts,Inc.hopesthatthesebusinesseswillfindaneededuse oftheirproduct,,duetoitslackoffunctionality.AirJetBestParts,Inc.hopes thisupgradewillhappenasbusinessesbecomemorefamiliarwiththeirsoftware.

c. ErosionCommonlyknownasdepreciation.Erosionoccurswhenthereissome

formofanegativeimpactonexistingassetswithinafirm.Example:AirJetBest Parts,Inc.stocksweretradingat$125.00ashareforthelast7days,andbecause ofamassrecallofsomedefectiveparts,AirJetBestParts,Inc.shareshave droppedsteadby10%forthepasttwodays,whichisknownaserosionor depreciationofassets.

6. Explainhowyouwouldconductascenarioandsensitivityanalysisoftheproject.What

wouldbesomeprojectspecificrisksandmarketrisksrelatedtothisproject?(20pts) Whendoingascenarioandsensitivityanalysis,firstcomputetheNPVforthedifferent scenariosi.e.changeswithinthe(RR)rateofreturn,(CF)cashflow,andanychanges relatedtothe(IC)initialcost.

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OncethisNPVNetPresentValueiscalculated,thefactorwhichreducestheNPV NetPresentValuetonegativevaluesshouldbeincorporatedtodeterminethefactors inwhichmaybesensitivefortheproject.

Task5:CostofCapital AirJetBestPartsInc.isnowconsideringthattheappropriatediscountrateforthenewmachine shouldbethecostofcapitalandwouldliketodetermineit.Youwillassistintheprocessof obtainingthisrate.

1. Computethecostofdebt.AssumeAirJetBestPartsInc.isconsideringissuingnew

bonds.Selectcurrentbondsfromoneofthemaincompetitorsasabenchmark.Key competitorsincludeRaytheon,Boeing,LockheedMartin,andtheNorthropGrumman Corporation.

a. WhatistheYTMofthecompetitorsbond?Youmayuseanumberofsources,

butwerecommendMorningstar.FindtheYTMofone15or20yearbondwith

thehighestpossiblecreditworthiness.Youmayassumethatnewbondsissuedby AirJetBestParts,Inc.areofsimilarriskandwillrequirethesamereturn.(5pts) 5.50%

b. Whatistheaftertaxcostofdebtifthetaxrateis34%?(5pts)

5.50%x34%=1.87%5.50%=3.63%
c. Explainwhatothermethodsyoucouldhaveusedtofindthecostofdebtfor

AirJetBestPartsInc.(10pts)

TheYieldtomaturity(YTM)methodcouldhavebeenused,whichwouldof allowedAirJetBestPartsInc.tocomputetheactualYTMofthenewbondissue byincorporatingallthecashflowassociatedwiththeissue,assumingthatthe bondwillbehelduntilitsmaturityandallscheduledpaymentsrelatingtothis bondwouldhavebeenmadeontime.Also,AirJetBestPartsInc.couldofused thismethodasanestimationoffuturereturnonabond,andadjustingforthe difference,ifany.

d. ExplainwhyyoushouldusetheYTMandnotthecouponrateastherequired

returnfordebt.(5pts)

Thecouponratecouldcauseaseriousdepreciationoffundsifthismethodisused because;thecouponrateusesthefacevalueofthebond,inordertocomputethe bond(s)value,anddoesnottakeintoconsiderationthepriceatwhichtheissueof thisbondwasortheredemptionvalueofthebond.TheYieldtomaturity(YTM) methodisbettertousebecausetheYieldtomaturity(YTM)methodincorporates allfluctuationsandtheissuingexpenses,ifany.Thus,theYieldtomaturity (YTM)methodisabettermethodtouse,andnotthecouponrateastherequired returnfordebt.

2. ComputethecostofcommonequityusingtheCAPMmodel.Forbeta,usetheaverage

betaofthreeselectedcompetitors.YoumayobtainthebetasfromYahooFinance. Assumetheriskfreeratetobe3%andthemarketriskpremiumtobe4%. RiskfreeRate 3%

Marketriskpremium,MRP Beta Competitors .65 DendreonCorp 1.40 DouglasEmmet 1.07 RaytheonCompany CommonStock AverageBeta 1.04

4% AsonOctober6,2010 http://finance.yahoo.com/q/ks?s=RTN+Key+Statistics http://finance.yahoo.com/q/ks?s=BA+Key+Statistics http://finance.yahoo.com/q/ks?s=LMT+Key+Statistics

a. Whatisthecostofcommonequity?(5pts)

Thecostofcommonequityistheannualrateofreturnthatacompany,business, investor,andsoonexpecttoearnwhentheyareinvestinginsharesofa company. Thecostofcommonequityistheriskfreerateplus(MRP*Beta)=7.16% .65+1.40+1.07=3.12dividedby3=AverageBeta1.04then3%+(4%x1.04)= 4.16%+3.00=7.16%

b. ExplaintheadvantagesanddisadvantagestousetheCAPMmodelasthemethod

tocomputethecostofcommonequity.Compareandcontrastthismethodwith thedividendgrowthmodelapproach.(10pts)

AdvantagesofCAPM:itisthemostrelevantwaytodeterminetherisktostockholders, andittakesintoaccountthesystematicriskofthestockwhichinrealityistheprimary riskheldinaninvestorsdiversifiedportfolio.

DisadvantagesofCAPM:thismodelhasavastnumberofhurdlesoranumberof variablesthataredependantonalotofcomputations,inordertoarriveattheCAPM equation.AnotherdisadvantageofCAPMisthatitassumesasingletimeperiodhorizon, whereastheinvestmentisgenerallyforamultipleperiod.

Incomparison,CAPMisabettermethodoverthedividendgrowthmodelapproach because,itconsidersthesystematicriskofastockandcanalsobecomputedfornon dividendpayingstock.Furthermore,theCAPMmodelisnotbiasedbythefuture projectionsofdividendspaymentofacompany.

3. Computethecostofpreferredequityassumingthedividendpaidforpreferredstockis $2.93andthecurrentvalueofthestockis$50pershare. Dividend Price $2.93 $50.00

a. Whatisthecostofpreferredequity?(5pts)

Costofpreferredequityis$2.93dividedby$50.00=0.0586or5.86%

b. Isthereanyothermethodtocomputethiscost?Explain.(5pts)

Yes,theYieldtomaturity(YTM)methodcouldbeusedtoincorporateallthe cashflowinvolvedassociatedwiththebondissue,assumingthatthebondwillbe helduntilitsmaturityandallscheduledpaymentsrelatingtothisbondwould havebeenmadeontime.

4. Assumingthatthemarketvalueweightsofthesecapitalsourcesare30%bonds,60%

commonequityand10%preferredequity,whatistheweightedcostofcapitalofthe firm?(10pts) CapitalStructure Bond CommonEquity PreferredEquity WeightCostofCapital Weights 30% 60% 10% Cost 3.63% 7.16% 5.86% Weightsx Cost 1.09% 4.29% 0.59% 5.97%

5. ShouldthefirmusethisWACCforallprojects?Explainandprovideexamplesas

appropriate.(10pts)

YesthefirmshouldusetheWACCforallprojectsbecause;theabovecomputationisnot projectspecific.

AslongasthecompanyusesthesameweightsthenitcanusetheaboveWACCforall theprojects.Ifthereisachangeintheweightsthenthecompanyhastoincorporatethe changesasrequiredand/orspecifiedtothatproject.

6. Recomputethenetpresentvalueoftheprojectbasedonthecostofcapitalyoufound.Do

youstillbelievethatyourearlierrecommendationforacceptingorrejectingtheproject wasadequate?Whyorwhynot?(5pts) Year 1 2 3 4 Cashflow $1,100,000 $1,450,000 $1,300,000 $950,000 Presentfactor@ 5.97% Presentvalue $1,038,020 $1,291,201 $1,092,401 $753,313 $4,174,936 $(3,000,000) $1,174,936

0.9437 0.8905 0.8403 0.7930 Total= Less:Initialcost= NPV=