Managerial Finance- ATC Corp, cost of capital, investment

Directions: Read the information about ATC Corporation and use it to answer each of the following questions. Be detailed and complete in your answers, referring to any appropriate numbers. Use Word to type your answers and use Excel to do any necessary calculations.

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 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. 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
Cost Savings 400,000 420,000 440,000 460,000 480,000
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.