will Introduction
You assume that you still work as a financial analyst for AirJet Best Parts, Inc. The
company is considering a capital investment in a new machine and you are in charge of
making a recommendation on the purchase based on (1) a given rate of return of 15%
(Task 5) and (2) the firms cost of capital (Task 6).
Task 4. Capital Budgeting for a New Machine
A few months have now passed and AirJet Best Parts, Inc. is considering the purchase
on a new machine that will increase the production of a special component significantly.
The anticipated cash flows for the project are as follows:
Year 1
$1,100,000
Year 2
$1,450,000
Year 3
$1,300,000
Year 4
$950,000
You have now been tasked with providing a recommendation for the project based on
the results of a Net Present Value Analysis. Assuming that the required rate of return is
15% and the initial cost of the machine is $3,000,000.
1. What is the projects IRR? (10 pts)
Using a financial calculator or a trial and error approach the IRR should be
approximately 22%.
2. What is the projects NPV? (15 pts)
($1,100,000/1.15)+($1,450,000/1.15)^2+($1,300,000/1.15)^3+
($950,000/1.15)^4-3,000,000 = $450,867
3. Should the company accept this project and why (or why not)? (5 pts)
Yes, since NPV>0
4. Explain how depreciation will affect the present value of the project. (10 pts)
Answers will vary, students need to recognize depreciation is not a cash
flow, but would affect the tax amount paid on inflows from the project.
5. Provide examples of at least one of the following as it relates to the project: (5 pts
each)
a. Sunk Cost
b. Opportunity cost
c. Erosion
6. Explain how you would conduct a scenario and sensitivity analysis of the project.
What would be some project-specific risks and market risks related to this
project? (20 pts)
Answers will vary, students should provide some examples related to
forecasting risk or estimation errors on revenues or costs and erosion as
project-specific, and changes in economic conditions (inflation, interest
rates, political/legal risks) as well as new competitors as some market
risks.
Task 5: Cost of Capital
AirJet Best Parts Inc. is now considering that the appropriate discount rate for the new
machine should be the cost of capital and would like to determine it. You will assist in
the process of obtaining this rate.
1. Compute the cost of debt. Assume AirJet Best Parts Inc. is considering issuing
new bonds. Select current bonds from one of the main competitors as a
benchmark. Key competitors include Raytheon, Boeing, Lockheed Martin, and
the Northrop Grumman Corporation.
a. What is the YTM of the competitors bond? You may use a number of
sources, but we recommend Morningstar. Find the YTM of one 15 or 20
year bond with the highest possible creditworthiness. You may assume
that new bonds issued by AirJet Best Parts, Inc. are of similar risk and will
require the same return. (5 pts)
Assume 6.9% for Boeing.
b. What is the after-tax cost of debt if the tax rate is 34%? (5 pts)
After tax cost of debt = Cost of Debt x (1-t) = 6.79% (1-34%) = 4.48%
c. Explain what other methods you could have used to find the cost debt
for of AirJet Best Parts Inc.(10 pts)
Answers will vary, an alternative method would be to use the current
yield to maturity of the company's bonds or other long-term
securities.
d. Explain why you should use the YTM and not the coupon rate as the
required return for debt. (5 pts)
Answers will vary, the YTM is the rate that would reflect the current
return required by investors for similar risk debt and therefore, the
appropriate measure for the cost of capital (debt).
2. Compute the cost of common equity using the CAPM model. For beta, use the
average beta of three selected competitors. You may obtain the betas from
Yahoo Finance. Assume the risk free rate to be 3% and the market risk premium
to be 4%.
a. What is the cost of common equity? (5 pts)
Assume a beta of 1.31 for Boeing. Then the cost of equity would be:
Re=Rf+B(ERm Rf) = 3% + 1.31 (4%) = 8.24%
b. Explain the advantages and disadvantages to use the CAPM model as the
method to compute the cost of common equity. Compare and contrast this
method with the dividend growth model approach. (10 pts)
Answers may vary. Example: An advantage of the DGM model is its
simplicity. Some disadvantages are that: (1) can only be applied to
firms that pay dividends and not all firms do (2) requires a constant
dividend growth rate forever (which is usually not the case) (3) the
estimated cost of equity from this method is very sensitive to
changes in g, which is a very uncertain parameter; and (4) the model
does not explicitly consider risk. Two key advantages of the CAPM
approach are that the model explicitly incorporates the relevant risk
of the stock, and the method is more widely applicable than is the
DCF model, since the SML doesnt make any assumptions about the
firms dividends.
3. Compute the cost of preferred equity assuming the dividend paid for preferred
stock is $2.93 and the current value of the stock is $50 per share.
a. What is the cost of preferred equity? (5 pts)
Rp=D/P0 = 2.93/50=5.86%
b. Is there any other method to compute this cost? Explain. (5 pts)
Answers will vary. Example: Stocks are rated in a similar manner than
bonds do and therefore, an alternative method is to observe the return
required by similar preferred stock.
4. Assuming that the market value weights of these capital sources are 30% bonds,
60% common equity and 10% preferred equity, what is the weighted cost of
capital of the firm? (10 pts)
WACC for the example above:
WACC = 30%(4.48%)+60%(8.24%)
+10%(5.86%)=0.0134+0.0494+0.0059=6.87%
5. Should the firm use this WACC for all projects? Explain and provide examples as
appropriate. (10 pts)
Answers will vary. Students need to recognize that cost of capital will
depend on risk as well. Some divisions or projects may present an usually
high or low risk and thus, a different cost of capital would be appropriate.
6. Recompute the net present value of the project based on the cost of capital you
found. Do you still believe that your earlier recommendation for accepting or
rejecting the project was adequate? Why or why not? (5 pts)
Please refer to initial questions. If NPV>0 then the project should be
accepted.