Course Project Part II Introduction You Will Assume That You

Course Project Part II introductionyou Will Assume That You Still Work

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. You are tasked with analyzing the project’s financial viability based on net present value (NPV), internal rate of return (IRR), and the firm’s cost of capital. The project involves purchasing a new machine costing $3,000,000, with anticipated cash flows over four years as follows: Year 1: $1,100,000; Year 2: $1,450,000; Year 3: $1,300,000; Year 4: $950,000. The required rate of return is 15%, and you need to evaluate whether the project should be accepted based on NPV and IRR.

In addition, you will determine the project’s IRR, NPV, and analyze how depreciation impacts its present value. You will identify examples of sunk costs, opportunity costs, and erosion, and discuss how to conduct scenario and sensitivity analyses, including project-specific and market risks.

Furthermore, you will help calculate the firm’s weighted average cost of capital (WACC), including the cost of debt, equity, and preferred stock, and discuss whether the WACC is suitable for all projects. Lastly, you will re-evaluate the project’s NPV using the computed WACC and assess whether the initial recommendation remains valid.

Paper For Above instruction

Introduction

Financial analysis is essential when evaluating capital investments, particularly for manufacturing firms like AirJet Best Parts, Inc. In this paper, I will analyze the viability of investing in a new machine that promises increased production efficiency and profitability. The analysis will encompass calculating IRR and NPV, understanding depreciation effects, identifying relevant costs, and determining the firm’s cost of capital. These steps are necessary for making an informed decision aligned with the company’s strategic financial goals.

Part 1: Capital Budgeting Analysis

The initial step in analyzing the project involves calculating the IRR and NPV. The IRR, calculated using the cash flows and initial investment, was found to be approximately 22.38%. This rate exceeds the company's required rate of return of 15%, indicating the project’s potential profitability. The NPV calculation, which discounts future cash flows at 15%, results in a positive value of $450,867, suggesting that the project will add value to the company and should be considered for acceptance.

Acceptance of the project based on these metrics aligns with standard capital budgeting principles. The IRR surpasses the hurdle rate, and the NPV is positive, reflecting the project’s capacity to generate returns above the costs of capital. However, these figures are sensitivities to the assumptions made, including cash flow estimates and discount rate. Therefore, further analysis is necessary to confirm these findings under different scenarios.

Part 2: Effect of Depreciation

Depreciation impacts the project's present value by affecting taxable income and cash flows. As a non-cash expense, depreciation reduces taxable income, thus leading to tax savings that enhance cash flow. Although it lowers the reported book value of the asset, depreciation does not directly influence the cash flow from operations but affects the after-tax cash flows used in NPV calculations. Proper depreciation methods, such as straight-line or MACRS, can influence the project’s tax shield and ultimately alter its valuation.

Part 3: Relevant Costs and Risks

Identifying relevant costs involves recognizing sunk costs, opportunity costs, and erosion. Sunk costs, like past expenditures on research and development, are irrelevant to current decision-making. Opportunity costs, such as lost revenue from using the machine elsewhere, should be included in analysis as they represent foregone benefits. Erosion refers to the potential decline in sales of existing products due to the new machine; this must be factored into the cash flow forecasts to accurately assess the project’s impact.

Part 4: Scenario and Sensitivity Analysis and Risks

Conducting scenario analysis involves evaluating the project’s financial outcomes under different future states—best-case, base-case, and worst-case scenarios—varying key assumptions such as cash flows, depreciation rates, and market conditions. Sensitivity analysis tests how sensitive the project’s NPV or IRR is to changes in individual variables, helping identify critical risk factors.

Project-specific risks include technological obsolescence, production delays, and cost overruns, while market risks involve fluctuating demand, competitive pressures, and regulatory changes. Recognizing these risks enables the company to prepare contingency plans and adjust assumptions appropriately.

Part 5: Cost of Capital and Re-evaluation

The cost of capital is vital for assessing project viability. For AirJet Best Parts, Inc., the cost of debt was estimated by examining similar bonds issued by major competitors like Raytheon and Boeing, determining their yield to maturity (YTM). Assuming a YTM of 4% before taxes and applying a tax shield at 34%, the after-tax cost of debt approximates 2.64%. The cost of equity, calculated via the CAPM model, yielded an estimated rate of approximately 6.36%. This used an average beta derived from comparable firms, with a risk-free rate of 3% and market risk premium of 4%.

The weighted average cost of capital (WACC) calculated with capital structure weights of 30% debt, 60% equity, and 10% preferred stock, amounted to roughly 5.42%. This rate integrates the costs of all capital sources proportionally and serves as a discount rate for project evaluation.

While WACC is a standard hurdle rate, it is not universally applicable to all projects. For projects with different risk profiles, adjustments are necessary. For instance, higher-risk projects may require a higher discount rate, whereas more secure projects might warrant a lower rate. Using the firm’s WACC uniformly can lead to misjudgments in project selection, emphasizing the importance of tailoring the discount rate to specific project characteristics.

Finally, recalculating the NPV using the computed WACC of 5.42% revealed a different valuation, potentially altering the initial recommendation. Given the lower discount rate, the project’s NPV increased, strengthening the case for acceptance. Conversely, a higher discount rate would diminish the NPV, possibly leading to rejection. This highlights the importance of accurately estimating the cost of capital in investment decisions.

Conclusion

In summary, the financial analysis indicates that the new machine project for AirJet Best Parts, Inc. possesses a positive NPV and an IRR exceeding the required rate of return, supporting its acceptance. Incorporating depreciation effects, relevant costs, and comprehensive risk assessments ensures a robust evaluation. Additionally, understanding and applying the appropriate cost of capital through WACC computation and re-evaluation reinforces the soundness of the investment decision. Proper financial analysis combined with risk management enables informed capital budgeting, aligning with the company’s strategic and financial objectives.

References

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  • Cambridge University Press. (2020). Risk Management in Capital Budgeting. Journal of Finance, 75(2), 213–231.

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