Busn379 Week 6 Course Project Part 2 Essay

1337 Words Feb 8th, 2013 6 Pages
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…
Disadvantages are that:
- it can only be applied to firms that pay dividends and not all firms do
- it requires a constant dividend growth rate forever (which is usually not the case)
- the estimated cost of equity from this method is very sensitive to changes in growth, which is a very uncertain parameter; and
- the model does not explicitly consider risk.

Advantages of the CAPM approach are:
- it clearly incorporates the relevant risk of the stock,
- it is more widely applicable than DGM sincethe SML doesn’t make any assumptions about the firm’s 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)
Since stocks are rated in a similar manner to bonds you could compute the cost by observing 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)

Cost of capital

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