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 14% (Task 4) and (2) the firm’s cost of capital (Task 5). NOTE: You need to show your work in order to receive full credit.
Task 4. Capital Budgeting for a New Machine
A few months have now passed and AirJet Best Parts, Inc. is considering the purchase of 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 $1,200,000
Year 2 $1,450,000 …show more content…
a. What is the YTM of the competitor’s 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)
b. What is the after-tax cost of debt if the tax rate is 35%? (5 pts)
c. Explain what other methods you could have used to find the cost of debt for AirJet Best Parts Inc.(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. For beta, use the average beta of three selected competitors (see 1. above for the names of 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%.
e. What is the cost of common equity? (5 pts)
f. Explain the advantages and disadvantages of using 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 $3.50 and the current value of the stock is $50 per