Task 5: Cost of Capital AirJet Best Parts Inc. is now considering that the appro
ID: 2672284 • Letter: T
Question
Task 5: Cost of CapitalAirJet 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
Explanation / Answer
1)
b.What is the after-tax cost of debt if the tax rate is 34%?
Cost of debt * (1-t) = 5.66% * (1-34%) = (5.66% - 1.9244%)
= 3.7356%
c. Explain what other methods you could have used to find the cost of debt forAirJet Best Parts Inc.
AirJet could have used the YTM method.Using this method would have allowed AirJet to compute the YTM ofthe new bond issue by incorporating all cash flows associated with theissue. You would also have to assume that the bond would be held untilits maturity date and all scheduled payments related to the bond would bemade on time. AirJet could also use this method to estimate future returnon a bond.
d. Explain why you should use the YTM and not the coupon rate as the requiredreturn for debt.
The coupon rate uses the face value of a bond tocompute the bond value. It does not take into consideration the price ofthe bond at its issue or the redemption value of the bond. As a result,using the coupon rate could cause a large depreciation of funds.
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2)
a. What is the cost of common equity?
Cost of common equity = Riskfree rate + (market risk premium * beta) = 3% + (4% * 0.8333)
= .03 + .033332= .063332
= 6.3332%
b. Explain the advantages and disadvantages to use the CAPM model as themethod to compute the cost of common equity. Compare and contrast thismethod with the dividend growth model approach.
CAPM Advantages: it is the most relevant way to determine the risk tostockholders, and it takes into account the systematic risk of the stock that isknown as the primary risk held in an investors’ diversified portfolio.
CAPM Disadvantages: In order to arrive at the CAPM equation, the CAPM modelhas a large number of computations that are dependent on a large number ofvariables. The CAPM model also assumes a single time period, whereas aninvestment generally spans for multiple time periods.
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) requiresa constant dividend growth rate forever (which is usually not the case) (3) theestimated cost of equity from this method is very sensitive to changes in g, whichis a very uncertain parameter; and (4) the model does not explicitly consider risk.
CAPM is a better method over the dividend growth model approach becauseit considers the systematic risk of a stock and can also be computed for non--dividend paying stock. Furthermore, the CAPM model is not biased by the futureprojections of dividends payment of a company.
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3)
a. What is the cost of preferred equity?
Cost of preferred equity =dividend paid / current value of stock
= 2.93/50 = .0586
= 5.86%
b. Is there any other method to compute this cost? Explain.
Stocks arerated in a manner similar to bonds. With this knowledge, an alternativemethod could be to observe the return that is required by similar preferredstock. You could also use the YTM method, but you would have to assumethat the bond will be held to maturity and all scheduled payments related tothe bond would be made on time.
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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 thefirm
WACC = 30%(3.7356%) + 60%(6.3332%) + 10%(5.86%) = 0.01121 +0.037992 + 0.00586
= 0.055062
= 5.5062%
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5. Should the firm use this WACC for all projects? Explain and provide examples asappropriate.
The weighted cost of capital equation is not project specific. If every project ina company had the same weights as those listed, you could use the equationexactly as it was used above. If there are different weights based upon risk, thenthe necessary changes must be made to the equation to fit the project.
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