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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 (). Select “Interest Rates” and then “Prime Bank Loan Rate”. Use the latest MPRIME. Show your calculations. (15 pts)
APR for National first = 3.25+6.75 = 10%
EAR for National first = 1.05^2-1 = 10.25
EAR for Regional best = 1.010975^12-1 = 14%
2. Based on your calculations above, which of the two banks would you recommend and why? Explain your rationale. (15 pts)
The EAR of Regional Best is higher by around 3.75% as compared to National first EAR of 10.25% therefore the National First should be selected.
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)
Monthly payment = 6950000/1-1/1.00717^60/.00717 = 6950000/48.622 = $142939.
EAR is equal to 1.00717^12-1 = 8.95%, it shows lower EAR as compared to EAR of National First which is 10.25%. It is also free from risk of change in prime rate as the loan is fixed.
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)
Boeing Price = 100.54 and last dividend was 1.94
Rate of return = 1.94/100.54+.05 = .069 or 6.9%.
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)
1.5*1.01/.069-.01 = $25.68
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)
The common stock will have higher price as there would be no growth factor in the preferred stock, as the rate of dividend is fixed for preferred stock. If suppose the required rate of return on preferred is also 6.9%, then the price would be 1.5/.069 = $21.74, which is lower than $25.68 price of common stock.
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)
The increase in dividend will increase the share price suppose the company decide to pay $1.60 per share the price will 1.60/.069-.01 = $27.12, but when the required rate of return is increased the price will go down suppose the required rate of return is 8% instead of 6.9%, the price will be 1.5*1.01/.08-.01 = $21.64
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)
37.5+1000-1062/40/1000+1062/2 = .03486 x 2 = .0697 or 7% should be the coupon rate.
2. What is the difference between the coupon rate and the YTM of bonds? (10 pts)
The coupon rate is the interest to be paid by the company on its face value. The YTM is calculated by considering the current market price of the bond. As the interest rate will remain same regardless of what the market price is therefore the yield to investor who buys bond from market at price different than the face value, the rate of return is not equal to coupon rate, therefore another rate is calculated, which is called YTM. If the market price is equal to face value of the bond, then there would be no difference in coupon rate and YTM.
3. What factors will contribute to the riskiness of these bonds? Explain in detail your rationale. (20 pts)
The three major factors are the market interest rate fluctuation, the maturity period and ability of the company to pay both principal amount and interest. If the new bonds are issued at rate different than the company had issued the bond, the price will fluctuate accordingly. As far as the maturity period, the more risk is involved. If the company has strong financial position to pay off its debts and interest, the risk is on lower side, but if it not strong, the risk is on higher side.
4. What type of positive and negative covenants may AirJet Best Parts, Inc. use in future bond issues? (10 pts)
Negative covenants may be restriction on use of some portion of earnings to pay dividend, as the cash flow to be kept for bondholders. Another negative covenant may be setting of ratio, such as debt equity ratio, it means that company cannot obtain debt if certain standard of ratio is not maintained.
Positive covenants may be the keeping some reserve of quick assets to pay off interest to the bondholders. It may also include the audit of company financial position on periodic basis.
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