Course Project – Part I

Introduction

The Course Project is an opportunity for you to apply concepts learned to a real-life simulation experience. Throughout the Course Project, you will assume that you work as a financial analyst for AirJet Best Parts, Inc. The Course Project is provided in two parts as follows:

Part I – In Part I, you work with AirJet Best Parts, Inc. staff to identify the best loan options, as well as to valuate stocks and bonds.

Part II – In Part II, you will provide the company with a recommendation for purchasing a new machine. You will base your recommendation on the Net Present Value (NPV) of the capital investment project using the cost of capital (WACC) as your discount rate.

About AirJet Best Parts, Inc.

AirJet Best Parts, Inc. is a company dedicated to the design and manufacturing of aviation and airplane technologies and parts. The company has commercial and military clients worldwide.

Task 1: Assessing loan options for AirJet Best Parts, Inc.

The company needs to finance $8,000,000 for a new factory in Mexico. The funds will be obtained through a commercial loan and by issuing corporate bonds. Here is some of the information regarding the APRs offered by two well-known commercial banks.

Bank

APR

Number of Times Compounded

National First

Prime Rate + 6.75%

Semiannually

Regions Best

13.17

Monthly

1. Assuming that AirJet Parts, Inc. is considering loans from National First and Regions Best, what are the EARs for these two banks? Hint for National Bank: Go to the St. Louis Federal Reserve Board’s website (http://research.stlouisfed.org/fred2/). Select “Interest Rates” and then “Prime Bank Loan Rate”. Use the latest MPRIME. Show your calculations. (15 pts)

2. Based on your calculations above, which of the two banks would you recommend and why? Explain your rationale. (15 pts)

3. AirJet Best Parts, Inc. has decided to take a $6,950,000 loan being offered by Regions Best at 8.6% APR for 5 years. What is the monthly payment amount on this loan? Do you agree with this decision? Explain your rationale. (20 pts)

Task 2: Evaluating Competitor’s Stock

AirJet Best Parts, Inc. is concerned regarding recent changes in its stock prices for the company and would like to determine the stock prices for key competitors. Key competitors include Raytheon, Boeing, Lockheed Martin, and the Northrop Grumman Corporation.

1. Using the dividend growth model and assuming a dividend growth rate of 5%, what is the rate of return for one of three key competitors? Use Yahoo Finance to obtain the latest dividend amount and price for one selected company. (15 pts)

2. Using the rate of return above, what should be the current share price of AirJet Best Parts, Inc. if the company maintains a constant 1% growth rate in dividends and the most recent dividend per share paid on the stock was $1.50? Show your calculations. (10 pts)

3. Assume AirJet Best Parts has also a preferred stock issue. The most recent dividend per share paid on the stock was also $1.50, the same as the common stock. Which one would you think has a higher price, the preferred stock or the current stock? Explain your rationale. (5 pts)

4. What would happen with the price you computed above if AirJet Best Parts, Inc. announces that dividends at the end of the year will increase? What if the required rate of return increases? What changes in dividends will affect the stock price and how? (10 pts)

Task 3: Bond Evaluation

AirJet Best Parts, Inc. would like to issue 20-year bonds to obtain remaining funds for the new Mexico plant. The company currently has 7.5% semiannual coupon bonds in the market that sell for $1,062 and mature in 20 years.

1. What coupon rate should AirJet Best Parts set on its new bonds to sell them at par value? (10 pts)

2. What is the difference between the coupon rate and the YTM of bonds? (10 pts)

3. What factors will contribute to the riskiness of these bonds? Explain in detail your rationale. (20 pts)

4. What type of positive and negative covenants may AirJet Best Parts, Inc. use in future bond issues? (10 pts)

PART 2

Course Project Part II

Introduction

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 (1) a given rate of return of 15% (Task 4) and (2) the firm’s cost of capital (Task 5).

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.

1. What is the project’s IRR? (10 pts)

2. What is the project’s NPV? (15 pts)

3. Should the company accept this project and why (or why not)? (5 pts)

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)

Task 5: Cost of Capital

AirJet Best Parts Inc. is now considering that the appropriate discount rate for the new machine should be the cost of capital and would like to determine it. You will assist in the process of obtaining this rate.

1. Compute the cost of debt. Assume AirJet Best Parts Inc. is considering issuing new bonds. Select current bonds from one of the main competitors as a benchmark. Key competitors include Raytheon, Boeing, Lockheed Martin, and the Northrop Grumman Corporation.

a. What is the YTM of the competitor’s bond? You may use a number of sources, but we recommend Morningstar. Find the YTM of one 15 or 20 year bond with the highest possible creditworthiness. You may assume that new bonds issued by AirJet Best Parts, Inc. are of similar risk and will require the same return. (5 pts)

b. What is the after-tax cost of debt if the tax rate is 34%? (5 pts)

c. Explain what other methods you could have used to find the cost of debt for AirJet Best Parts Inc.(10 pts)

d. Explain why you should use the YTM and not the coupon rate as the required return for debt. (5 pts)

2. Compute the cost of common equity using the CAPM model. For beta, use the average beta of three selected competitors. You may obtain the betas from Yahoo Finance. Assume the risk free rate to be 3% and the market risk premium to be 4%.

a. What is the cost of common equity? (5 pts)

b. Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast this method with the dividend growth model approach. (10 pts)

3. Compute the cost of preferred equity assuming the dividend paid for preferred stock is $2.93 and the current value of the stock is $50 per share.

a. What is the cost of preferred equity? (5 pts)

b. Is there any other method to compute this cost? Explain. (5 pts)

4. Assuming that the market value weights of these capital sources are 30% bonds, 60% common equity and 10% preferred equity, what is the weighted cost of capital of the firm? (10 pts)

5. Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (10 pts)

6. Recompute the net present value of the project based on the cost of capital you found. Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not? (5 pts)