BUSN 379 Course Project II

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Course Project Part II

Introduction

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) 

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