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 project’s IRR? (10 pts)
Using this online IRR Calculation Tool http://finance.thinkanddone.com/online-i… we get the following IRR…show more content… 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 * (1-t) = 6.79% (1-34%) = 4.48%
c. Explain what other methods you could have used to find the cost of debt for AirJet Best Parts Inc.(10 pts)
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)
YTM would reflect the current return required by investors for similar risk debt and therefore be a more 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)
If beta for Boeing is 1.31, 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