DeVry BUSN379 Course project part II

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DeVry BUSN379 Course project part II

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DeVry BUSN379 Course project part II

  1. 1. DeVry BUSN379 Course Project Part II Introduction You will 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 firm’s 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 project’s IRR? (10 pts) Using a financial calculator or a trial and error approach the IRR should be approximately 22%. 2. What is the project’s 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.
  2. 2. 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 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) 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 of debt for 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)
  3. 3. 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 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) 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. 4. 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.

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