Course Project Part II
You will assume that you still work as a financial analyst for AirJet Parts. 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 (Task 4) and (2) the firm’s cost of capital (Task 5).
NOTE: You are to submit your work using the Project 2 template provided in the “Course Project Requirements Files” area under the “Doc Sharing” tab in the course shell. Assignments will not be accepted if this template is not used.
Task 4. Capital Budgeting for a New Machine
A few months have now passed and AirJet Parts 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 $850,000
Year 2 $912,000
Year 3 $978,000
Year 4 $1,040,000
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 13.75% and the initial cost of the machine is $3,125,000:
1. What is the project’s IRR? (10 pts)
2. What is the project’s NPV? (15 pts)
3. Should the company accept this project and why (or why not)? (5 pts)
4. Explain how depreciation will affect the present value of the project. (10 pts)
5. Explain why NPV and IRR are better methods to use for this decision than the Payback method: (15 pts)
6. Assuming that you were going to do a sensitivity analysis of this project, what would be some project-specific risks and market risks that should be incorporated into that analysis? (20 pts)
Task 5: Cost of Capital
AirJet Parts is now of the opinion that the appropriate discount rate for the new machine should be the cost of capital. They would like to calculate it and have asked you to assist in the process of obtaining this rate.
1. AirJet Parts is considering issuing new bonds and has decided to use Deere and Company (Stock Symbol: DE) as a comparison company.
a. What is the YTM of the comparison company’s long-term 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 Parts are of similar risk and will require the same return. Be sure to include the date you obtained this estimate from Morningstar. (5 pts)
b. What is the after-tax cost of debt if the tax rate is 32%? (5 pts)
c. Explain what other methods you could have used to find the cost of debt for AirJet Parts (10 pts)
d. Explain why you should use the YTM and not the coupon rate as the required return for debt. (5 pts)
2. Compute the cost of common equity using the CAPM model. Use the beta for DE, an appropriate comparison company. You may obtain the betas from Yahoo or Google Finance. Assume the risk free rate to be 1.85% and the market risk premium to be 9.25%.
a. What is the cost of common equity? (5 pts)
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)
3. Compute the cost of preferred equity assuming the dividend paid for preferred stock is $2.75 and the current value of the stock is $31.25 per share.
a. What is the cost of preferred equity? (5 pts)
b. Is there any other method to compute this cost? Explain. (5 pts)
4. Assuming that the market value weights of these capital sources are 25% bonds, 70% common equity and 5% preferred equity, what is the weighted cost of capital of the firm? (10 pts)
5. Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (5 pts)
6. Recompute the net present value of the project based on AirJet Parts’ cost of capital that you just calculated for Task 4 above. Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not? (10 pts)