As a financial analyst specializing in the aerospace industry for USC Pension & Investment, Inc. , you are asked by your managing partner, Mr.. Adam Smith, to evaluate the potential of this new GAWPS project. Initially, Allied Products will need to acquire $42 million in production equipment to make the GAWPS. The equipment is expected to have a seven-year useful life. This equipment can be sold for $12 million at the end of five years. Allied Products intends to sell two different versions of the GAWPS:
New GAWPS – intended for installation in new aircraft. The selling price is $70,000 per system and the variable cost of production is $50,000 per system. (Assume cash flows occur at year-end. )
Upgrade GAWPS – intended for installation on existing aircraft with an older version ground proximity radar in place. The selling price of the Upgrade system is $35,000 per system and the variable cost to produce it is $22,000 per system. Allied Products intends to raise prices at the same rate as inflation. Variable costs will also increase with inflation.
In addition, the GAWPS project will also incur 3 million in marketing and general administration costs the first year (expected to increase at the same rate as inflation). Allied Products’ corporate tax rate is 40 percent. Assume that the equity beta estimated by your equity analyst is 1. 2 and is the best estimate of Allied Products’ beta. The risk-free rate is estimated by the Treasury bill and has a rate of 2. 80 percent and the 500 recent years’ historical average excess return (i. E. , the market return less the Treasury bill rate) is 8. 3 percent. Annual inflation is expected to remain constant at 3 percent.
Further, suppose Allied Products’ bonds currently sell for $1, 120 (par value $1,000) and have 10 years left to maturity. The coupon rate 9%, paid semiannually. Its debt-to-equity ratio is 50 percent and will remain at 50 percent for at least five years.
Commercial Aircraft Market
The state of the economy has a major impact on the airplane manufacturing industry. Airline industry analysts have the following production expectations, depending on the annual state of the economy for the next five years.
Due to FAA regulations, all existing aircraft will be required to get an upgraded ground proximity warning system within the next five years, again, not necessarily from Allied Products. Allied Products believes the upgrades of the existing aircraft fleet will be spread evenly over the five years (the time value of money would suggest manufacturers defer purchasing upgrades until the fifth year; however, consumer demand for the additional safety will induce earlier upgrades). Allied Products uses an 8-year diminishing value schedule with a 30% appreciation rate.
The immediate initial working capital requirement is $2 million and thereafter the net working capital requirements will be 5 percent of sales. Allied Products has a number of competitors both in the new GAWPS and upgrade GAWPS markets but expects to dominate the market with a 40 percent share. While Allied Products expects a 40 percent market share, it could be as low as 25 percent and as high as 60 percent. Mr.. Smith has asked you to find the minimum market share under the moderate growth and mild recession assumption that till allows the project to proceed.
Scenario analysis Finally, the management is uncertain about the price and costs of providing the new equipment. Allied Products competitors will be competing in this market. In addition to affecting market share, there may be an effect on prices as well (plus or minus 10%). Variable costs are also expected to fluctuate by the same percentage as prices. You have been requested to conduct a sensitivity and scenario analysis for the moderate growth and mild recession cases with prices and costs subject to uncertainty.