You will assume that you still work as a financial analyst for AirJet Best Parts

Question

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 a given rate of return of 15% (Task 4).

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
Year 2 $1,450,000
Year 3 $1,300,000
Year 4 $950,000

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.

4. Explain how depreciation will affect the present value of the project. (10 pts)

5. Provide examples of at least one of the following as it relates to the project: (5 pts each)
a. Sunk Cost
b. Opportunity cost
c. Erosion

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)

Explanation / Answer

-3000000 1100000 1450000 1300000 950000 Using this online NPV Calculation Tool http://finance.thinkanddone.com/online-n… we get the following NPV at 15% Net Cash Flows CF0 = -3000000 CF1 = 1100000 CF2 = 1450000 CF3 = 1300000 CF4 = 950000 Discounted Net Cash Flows DCF1 = 1100000/(1+0.15)^1 = 1100000/1.15 = 956521.74 DCF2 = 1450000/(1+0.15)^2 = 1450000/1.3225 = 1096408.32 DCF3 = 1300000/(1+0.15)^3 = 1300000/1.52087 = 854771.1 DCF4 = 950000/(1+0.15)^4 = 950000/1.74901 = 543165.58 NPV Calculation NPV = 956521.74 + 1096408.32 + 854771.1 + 543165.58 -3000000 NPV = 3450866.74 -3000000 NPV = $450,866.74 Using this online IRR Calculation Tool http://finance.thinkanddone.com/online-i… we get the following IRR Discounted Net Cash Flows at 19% DCF1 = 1100000/(1+19%)^1 = 1100000/1.19 = 924369.75 DCF2 = 1450000/(1+19%)^2 = 1450000/1.4161 = 1023938.99 DCF3 = 1300000/(1+19%)^3 = 1300000/1.68516 = 771440.56 DCF4 = 950000/(1+19%)^4 = 950000/2.00534 = 473735.31 NPV Calculation at 19% NPV = 924369.75 + 1023938.99 + 771440.56 + 473735.31 -3000000 NPV = 3193484.61 -3000000 NPV at 19% = 193484.61 Discounted Net Cash Flows at 24% DCF1 = 1100000/(1+24%)^1 = 1100000/1.24 = 887096.77 DCF2 = 1450000/(1+24%)^2 = 1450000/1.5376 = 943028.1 DCF3 = 1300000/(1+24%)^3 = 1300000/1.90662 = 681833.44 DCF4 = 950000/(1+24%)^4 = 950000/2.36421 = 401824.92 NPV Calculation at 24% NPV = 887096.77 + 943028.1 + 681833.44 + 401824.92 -3000000 NPV = 2913783.23 -3000000 NPV at 24% = -86216.77 IRR with Linear Interpolation iL = 19% iU = 24% npvL = 193484.61 npvU = -86216.77 irr = iL + [(iU-iL)(npvL)] / [npvL-npvU] irr = 0.19 + [(0.24-0.19)(193484.61)] / [193484.61--86216.77] irr = 0.19 + [(0.05)(193484.61)] / [279701.38] irr = 0.19 + 9674.2305 / 279701.38 irr = 0.19 + 0.0346 irr = 0.2246 irr = 22.46% The company should accept this project since its IRR is higher than the required rate of return and it has a positive NPV

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