Mr. Adam Smith, from USC Pension & Investment, Inc., has assigned you the responsibility of assessing the financial potential of the new GAWPS project as an aerospace industry specialist analyst. The project requires an initial investment of $42 million for production equipment that is expected to have a lifespan of seven years. Additionally, after five years, it can be sold for $12 million. Allied Products intends to market two different versions of the GAWPS.
The New GAWPS is designed to be installed in new aircraft. It is sold at a price of $70,000 per system, with a variable production cost of $50,000 per system. (Assume cash flows occur at year-end.)
The Upgrade GAWPS system is intended for installation on aircrafts that currently have outdated ground proximity radar. The cost per unit of the system is $35,000, with a variable production cost of $22,000. Allied Products intends to adjust prices based on inflation and anticipates a corresponding increase in variable costs.
Furthermore, the GAWPS project will have marketing and general administration costs of 3 million in its first year. These costs are expected to increase at the same rate as inflation. Allied Products’ corporate tax rate is 40 percent. According to your equity analyst, a beta of 1.2 has been estimated for Allied Products, which is considered the most accurate measure of their beta. The risk-free rate, determined by Treasury bill rates, is currently at 2.80 percent. Over the past 500 years, the average excess return (calculated by subtracting the Treasury bill rate from market return) has been 8.3 percent. Annual inflation is projected to remain constant at 3 percent.
Moreover, let’s suppose that Allied Products’ bonds are presently being traded at $1,120 (with a par value of $1,000) and still have 10 years left to mature. These bonds possess a coupon rate of 9%, which is paid every six months. Additionally, Allied Products maintains a debt-to-equity ratio of 50%, which will remain unchanged for at least the subsequent five years.
Commercial Aircraft Market
The airplane manufacturing industry is heavily influenced by the condition of the economy. Analysts in the airline industry have outlined production expectations for the next five years, taking into account the annual state of the economy.
According to FAA regulations, all current aircraft must have an improved ground proximity warning system in the next five years. This upgrade does not have to be obtained from Allied Products. Allied Products anticipates that the upgrades for existing aircraft will be evenly distributed over the next five years. However, considering the time value of money, manufacturers may postpone purchasing upgrades until the fifth year. Nevertheless, consumer demand for increased safety is expected to prompt earlier upgrades. Allied Products follows 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 competitors in both the new GAWPS and upgrade GAWPS markets, but it aims to dominate the market with a 40 percent share. However, the expected market share could range from 25 percent to 60 percent. Mr. Smith has requested to determine the minimum market share under the moderate growth and mild recession assumption that still allows the project to proceed.
Due to uncertainty regarding the price and costs of the new equipment, scenario analysis is necessary for management. This is especially important because competitors of Allied Products will be entering the market, potentially affecting market share. Moreover, there may be a fluctuation in prices by plus or minus 10%, which could also impact variable costs by the same percentage. As a result, you have been tasked with conducting sensitivity and scenario analyses for both moderate growth and mild recession scenarios, taking into consideration the uncertainties surrounding prices and costs.