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# 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

## 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)

## 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.

c. ErosionCommonlyknownasdepreciation.Erosionoccurswhenthereissome

6. Explainhowyouwouldconductascenarioandsensitivityanalysisoftheproject.What

-

## OncethisNPVNetPresentValueiscalculated,thefactorwhichreducestheNPV NetPresentValuetonegativevaluesshouldbeincorporatedtodeterminethefactors inwhichmaybesensitivefortheproject.

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)

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

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%

tocomputethecostofcommonequity.Compareandcontrastthismethodwith thedividendgrowthmodelapproach.(10pts)

## 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)

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