ATC Corporation is a manufacturer of new and replacement parts for the aircraft
ID: 2757721 • Letter: A
Question
ATC Corporation is a manufacturer of new and replacement parts for the aircraft industry. The company’s major customers are airlines, other aircraft operators (such as charter services), and contract maintenance service providers. Despite the economic slowdown, the company expects its sales to be strong for the several years, since many aircraft operators will be more interested in maintaining and repairing existing planes rather than buying new ones.
At the present time, ATC is considering an upgrade to its manufacturing facility. This will involve replacing several older machines by the purchase and installation of a new, state of the art, computer-controlled metal cutting and shaping machine center made by a German supplier. Estimates of the machine center’s costs and benefits are shown in the table below, where net cash flows are after-tax. Although the machinery should last for at least ten years, the company uses a five-year planning period for equipment of this type (based on depreciation rules and company policy). Since the machine will not be sold at the end of year 5, there is no salvage value to consider.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Initial Costs:
Purchase
-3,600,000
Shipping
-150,000
Installation
-250,000
Cash Inflows:
Sale of Old Machines
200,000
Investment Tax Credit
350,000
After-Tax Cost Savings
400,000
420,000
440,000
460,000
480,000
After-Tax New Sales
0
50,000
100,000
120,000
150,000
Depreciation Tax Savings
350,000
600,000
430,000
300,000
200,000
Increased Product Quality
10,000
20,000
25,000
30,000
35,000
Net Cash Flows:
-3,450,000
760,000
1,090,000
995,000
910,000
865,000
Three important things to note are that the above cash flows have been adjusted to include an assumed inflation rate of 3% per year, the company’s average tax rate is 30%, and that the investment project is considered to be 20% riskier than the company’s average investment.
Examination of ATC’s balance sheet reveals that the company uses the following types of financing (all percentages are based on market value).
Financing Type
Percentage of Total Financing
Market Rate of Return
Short-Term Debt
15%
3.5%
Long-Term Debt
30%
5.25%
Preferred Equity
10%
8%
Common Equity
45%
12%
If ATC does not make this equipment investment, it has no other real asset investment projects which it is considering. Therefore, an alternative use of the money in the capital budget would be a purely financial investment, such as stock, bonds, short-term CD’s, and so forth.
1.Based on your knowledge of current and projected economic conditions, does the company’s assumption about future sales sound reasonable to you? Why or why not?
2.What cost of capital should the company use to analyze this investment project?
3.Without considering any other alternatives, is the machine a good investment for the company? Why or why not?
4.Without doing any calculations, discuss some possible alternatives which the company might have in terms of financial investments. Give some specific examples and make sure that you include a consideration of risk as part of your discussion.
5.Which choice would you recommend for the company? Why do you consider this option the best choice?
6.Suppose you are convinced that inflation over the next several years will be higher than the 3% which is forecast in the numbers the company is using in their projections. Without doing any further calculations, explain how you could adjust your analysis to account for this.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Initial Costs:
Purchase
-3,600,000
Shipping
-150,000
Installation
-250,000
Cash Inflows:
Sale of Old Machines
200,000
Investment Tax Credit
350,000
After-Tax Cost Savings
400,000
420,000
440,000
460,000
480,000
After-Tax New Sales
0
50,000
100,000
120,000
150,000
Depreciation Tax Savings
350,000
600,000
430,000
300,000
200,000
Increased Product Quality
10,000
20,000
25,000
30,000
35,000
Net Cash Flows:
-3,450,000
760,000
1,090,000
995,000
910,000
865,000
Explanation / Answer
Answer:1 There is no indication of why the firm expects strong sales in the midst of an economic slowdown. There are products that are "counter cycle" and would do well in a slowdown. For instance, McDonalds has done extremely well after the 2008 economic crisis as people downgraded from higher cost restaurants to lower cost choices. It may be true that those with an airline hobby will be more likely to do their own repairs in a downturn. The car repair industry has been booming since the downturn in 2008. However, the car and airline industry has an important difference. People need their cars. Flying is optional. That is, those with an airline hobby, a rather expensive hobby I might add, would be likely to stop flying until the economy recovers as it is a discretionary cost. And what percent of their sales is the hobby industry? Overall, I would not believe the sales assumption is not reasonable.
Answer:2
Financing Type Percentage of Total Financing Market Rate of Return WACC Short-Term Debt 15% 3.50% 0.52500% Long-Term Debt 30% 5.25% 1.57500% Preferred Equity 10% 8% 0.80000% Common Equity 45% 12% 5.40000% 8.30000%Related Questions
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