Considering a capital investments


You will assume that you still work as a financial analyst for Aero Faust, 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 minimum rate of return of 12% (Task 4) and (2) the firms cost of capital (Task 5).

PART II Here is how you will be graded: Possible
Task 4: Assessing loan options  
  Step 1: Calculate IRR 10
  Step 2: Calculate NPV 10
  Step 3: Decision 5
  Step 4: Explain how depreciation will affect the NPV 5
  Step 5: Explain and Provide examples of each of the following:  
  A.Sunk cost 5
  B.Opportunity cost 5
  C. Erosion 5
  Step 6: Explain how you would conduct a scenario and sensitivity analysis 10
Task 5: Cost of Capital  
  Step 1: Cost of Debt  
  A. What is the Briggs & Stratton coupon rate? 5
  B. What is the Briggs & Stratton YTM? 5
  C. Provide a screen shot of competitor’s bond analysis page 5
  D. What is the YTM of the competitors bond? 5
  E. Calculate the ATK 5
  F. Why use the YTM and not the coupon rate 5
  Step 2: Cost of Common Equity  
  A. Screen Shot 5
  B. Compute the cost of common equity using the CAPM 10
  C. Compare/contrast the CAPM with the dividend growth model (DGM) 10
  Step 3: Cost of Preferred Equity  
  A. Compute the cost of Preferred Equity using the DGM with no growth 10
  B. Other methods to compute the Cost of Preferred Equity 5
  Step 4: Calculate WACC 10
  Step 5: Should the firm use this WACC for all projects 5
  Step 6: Re-compute the NPV  
  A. Re-compute the NPV of the project above using the new WACC. 5
  B. Would you change your earlier recommendation? Explain. 5
  Late Penalty -15 points  
TOTAL   150

As with all written work, if you quote other works, you must provide a proper APA reference citation and at least 80% of each response must be your own, original commentary. Use quoted material to SUPPORT your opinion, not to BE your opinion.

Task 4. Capital Budgeting for a New Machine

A few months have now passed and Aero Faust, 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 $1,200,000

Year 3 $1,300,000

Year 4 $1,400,000

Year 5 $1,500,000

Year 6 $1,600,000

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 12% and the initial cost of the machine is $5,500,000.

1.What is the projects IRR?Show your calculations and display your answer to the nearestTWO decimal places(like this: 12.34%). (10 pts)

2.What is the projects NPV? Show your calculations and display your answer to the nearest whole dollar (Withno decimals– like this: $12). (10 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. (5 pts)

5.Explain each of the following as and provide examples as they might relate to this proposal. (5 pts each)

a.Sunk Cost

b.Opportunity cost


6.What is a sensitivity analysis and how might it help identify project-specific risks and market risks related to this project? (10 pts)

Task 5: Cost of Capital

Aero Faust, 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 Aero Faust, Inc. is considering issuing new bonds. Select current bonds from one of its main competitors, Raytheon, Boeing, Lockheed Martin, or the Northrop Grumman Corporation as a benchmark return for the new bonds.

You may use a number of sources to get bond information about a comparable firm to use as a benchmark. We recommend Morningstar. But Morningstar is a little difficult to navigate so you will find it much easier to search directly from your search engine (Google or Yahoo) for the desired firms bonds and selecting Morningstar from the list of web pages. (For example, search for Boeing bonds Morningstar.)


Here is a sample of the correct page for an unrelated company, Briggs & Stratton (BBG), manufacturer of Simplicity garden tractors.




Scroll down to see a list of bonds issued by your benchmark company.




Briggs has only issued one bond which matures in 2020. The aerospace firm you select will have many.Select the one with the longest maturity date. You may assume that new bonds issued by Aero Faust, Inc. are of similar risk and will require the same return.


a.In the Briggs & Stratton example above, what is the coupon rate? (5 pts)


b.What is Briggs & Stratton Yield to Maturity (YTM)? (5 pts)


c.Provide a screen shot of the competitors bond page you selected. (5 pts)


d.What is the YTM of the competitors bond you have selected? (5 pts).

e.Assume that the competitor you selected has a marginal tax rate of 33%. Calculate the after-tax cost of debt. Show your calculations and display your answer to the nearest TWO decimal places (like this: 12.34%). (5 pts)

f.Explain why you should use the YTM and not the coupon rate as the required return for debt. (5 pts)

2.The cost of common equity may be derived using the CAPM model. For beta, use theaverage beta of three competitors. You may obtain the betas from LexisNexis (in the course Home tab, select Student Resources, then select Library, Databases, then LexisNexis.) You can also get the information you need from Google Finance or Yahoo Finance.

a.Provide a screen shot of the benchmark competitor you selected. (5 pts)


b.Assume the risk free rate to be 2.5% and the average market return to be 6.5%. Using the CAPM model, what is the cost of common equity? show your calculations and display your answer to the nearest TWO decimal places (like this: 12.34%). (10 pts)


c.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.One method to calculate the required rate of return on preferred stock is to use the Gordon Model, also called the Dividend Growth Model. But with preferred stock, dividends are always the same and never change. The growth factor is, therefore, zero.


a.Using the dividend growth model with zero growth, assuming the dividend paid on preferred stock is $4.50 and the current value of the stock is $80 per share; compute the cost of preferred equity. Show your calculations and display your answer to the nearest TWO decimal places (like this: 12.34%). (10 pts)

b.What other means could we use to compute the cost of preferred equity? Explain. (5 pts)

4.Assuming that the market value weights of these capital sources are 25% bonds, 45% common equity and 30% preferred equity, what is the weighted cost of capital of the firm? Show your calculations and display your answer to the nearest TWO decimal places (like this: 12.34%). (10 pts)

5.Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (5 pts)


6.Re-compute the net present value of the project using the cost of capital you found in Task 5 Question 4 above. Show your calculations. Do you still believe that your earlier recommendation for accepting or rejecting the project was appropriate? Why or why not? (10 pts)

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