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Introduction

You will assume that you still work as a financial analyst for Aero-Botics, 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 12% and (2) the firm's cost of capital.

A few months have now passed and Aero-Botics, 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 $750,000

Year 2 $1,000,000

Year 3 $1,100,000

Year 4 $1,150,000

Year 5 $1,200,000

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 $3,500,000.

Task 5: Cost of Capital

Aero-Botics 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-Botics 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 Aero-Botics, Inc. are of similar risk and will require the same return.

b. What is the after-tax cost of debt if the tax rate is 34%?

c. Explain what other methods you could have used to find the cost of debt for Aero-Botics Inc.

d. Explain why you should use the YTM and not the coupon rate as the required return for 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 average market rate is expected to be 8%.

a. What is the cost of common equity?

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.

3. Compute the cost of preferred equity assuming the dividend paid for preferred stock is $3.00 and the current value of the stock is $50 per share.

a. What is the cost of preferred equity?

b. Is there any other method to compute this cost? Explain.

4. Assuming that the market value weights of these capital sources are 35% bonds, 55% common equity and 10% 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.

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?

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