Course Project Part II Busn379

AirJet Best Parts Financial Analysis

A financial decision for the purchase of new equipment will be based on the projects IRR and NVP. Below I have included the IRR and NPV to help assist in the financial decisions for the project. Capital budgeting for a new machine 1.) The IRR is 22.38% 2.) The NVP is $450,867.00 NVP formula is as followed: Year 1 = 1100000/(1+0.15)^1 = 1100000/1.15 = 956521.74 Year 2 = 1450000/(1+0.15)^2 = 1450000/1.3225 = 1096408.32 Year 3 = 1300000/(1+0.15)^3 = 1300000/1.52087 = 854771.1 Year 4 = 950000/(1+0.15)^4 = 950000/1.74901 = 543165.58 Year 1 2 3 4 Cash flow 1,100,000 1,450,000 1,300,000 950,000 Total NVP x15% 0.8696 0.7561 0.6575 0.5718 Present Value $956,522 $1,096,408 $854,771 $543,166 (3,000,000) $450,867.00

3.) In my opinion the company should accept the project based on the financial gain of the project.

4.) Depreciation can have varying affects on different projects. In the case of this

project depreciation would actually be a positive thing. Deprecation in an accounting income typically does not reduce cash flows. In fact, they can have a significant positive impact on cash flows, if they affect the tax liability of the firm. In this case it would be positive for the company because it would save on taxes while increasing present value.
5.) Examples as related to the project:

a. Sunk cost- A cost that cannot be recovered because the funds are already spent. An example of a sunk cost for AirJet best Parts could be: AirJets Best made an investment of $500,000 to provide project research through an extensive survey. This would be a sunk cost because once the survey was completed the money could not be recovered.

b. Opportunity Cost- This is the cost of giving up one thing for another. An example of opportunity cost for AirJet Best could be the company providing other companies with partial repair services for a year with a minimal cost with hopes of making more money by providing full service repairs to returning customers.

c. Erosion- A negative impact on one or more of a companys existing assets. An example of this could be: AirJet Best stocks were trading at a rate of $100 over a said period. During this time AirJet production on a popular item has come to a halt because the company is out of stock on a key component of the part. They are unable to receive the part for 2 days resulting in a drop of 15%. This would be an example of erosion or depreciation.

6.) While conducting a scenario and sensitivity analysis of the project I would first compute the NVP for any changes that occurred within the cash flow. Some project specific risks could include defects in the new project equipment or not yielding the desired results with the equipment. Market risks usually arise from the lack of demand for a certain product or service, changing industry structures, or pricing instability. Related market risks could

include: a change in the demand of the special component that is being produced by the new machinery.

Cost of Capital

1.) Cost of debt

a. Competitor YTM rate of Boeing is 2.39 b. 2.39 x 34% = .81% - 5.50% =(4.69%) c. The YTM could have been utilized, allowing the company to estimate the return on the bond in the future. It could have also been used to accurately determine the new bond by taking into account all thing related to the companys cash flow. d. The YTM would be beneficial because it calculates all subjects pertaining to the bond (any fluctuations or initial cost, ect). Coupon rate uses only face value of the bond and should not be used because it could cause erosion. It also does not consider issuing cost or redemption value.

2.) Using the CAPM model I have computed the cost of common equity using the average beta of Boeing (1.11), Raytheon (0.75), and Lockheed Martin (0.64). Average= .83

a. The cost of common of equity is the expected annual rate of return from a business or shareholder, while they are investing in shares of a company. 3%+ (4% * .83) = 6.32 b. Advantages: considers systematic risks of the stock and it is the most effective way to determine risks.

Disadvantages are: assumes single time period horizon instead of the more practical multi period (which is the case with most bonds) and the number of variables in the equations can be overwhelming. Comparison to dividend growth- Overall the CAPM model is better because it figures systematic risks into evaluating the bond. It can also calculate the non dividend paying stock, whereas, the dividend growth model does not.

3.) Cost of preferred equity is: a. $2.93 divided by $50.00 = 0.0586 or 5.86% b. Another method to compute the cost of preferred equity would be the YTM method. This could be used only if the payments are assumed to be made on time and that it is held to maturity.

4.) The weighted cost of capital of the firm is as follows: Weights of Capitals 30% 60% 10% Costs 3.63% 7.16% 5.86% WxC 1.09% 4.29% 0.59% 5.97

Bond Common Equity Preferred Equity

Bond 30%* 3.63% = 1.09% Common Equity 60% * 7.16% = 4.29% Preferred Equity 10% * 5.86%= 0.59% Weight Cost of Capital 5.97%

5.) I think that WACC should be used for all projects because each component of the capital is proportionately weighted. All capital sources are included such as: common stock, preferred stock, bonds, and any other source of long term loan. Using the WACC is a good way to determine the risk of the investment because it

increases as beta and rate of return on equity increases. An increase in WACC indicates a decrease in value and means higher risks.

6.) Based on the cost of capital I would recommend avoiding the project because the new NPV is only $1,174,936. Which I believe could result in a negative since NPV at the cost of capital may not account for opportunity cost. Such as comparison with other available investments. What appears to be a positive NVP may not leave a margin large enough to cover hidden or unexpected cost. Therefore, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV would be the hands down wise choice.

Year 1 2 3 4

Cash flow 1,100,000 1,450,000 1,300,000 950,000 Total NVP

X5.97% 0.9437 0.8905 0.8403 0.7930

Present Value $1,038,020 $1,291,201 $1,092,401 $753,313 (3,000,000) $1,174,936