Cost of Capital, Math Problem Example

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. Please state which competitors you used!

Boeing

Institutional, $100k

Individual, $1k

http://www.boeing.com/news/frontiers/archive/2002/june/i_fof.html

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)

4%

http://quicktake.morningstar.com/StockNet/bonds.aspx?symbol=BA

b. What is the after-tax cost of debt if the tax rate is 34%? (5 pts)

= pre-tax cost of debt * (1-tax rate)

Pre-tax cost of debt = YTM

=.04*(1-.34)

2.64%

c. Explain what other methods you could have used to find the cost of debt for AirJet Best Parts Inc. (10 pts)

Coupon rate

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

Bonds do not make annual or semi-annual payments.

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%.

Boeing,           1.10

Lockheed,       .640

Northrup,        1.01

Average          .917

a. What is the cost of common equity? (5 pts)

= .03+.917(.04-.03)

= .039

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)

Advantages

1. Eliminates unsystemic risk
2. Theoretically derived, empirically verified
3. Systemic risk reltive to stock

Disadvatanges

1. Requires risk-free rate of return
2. Single period horizon
3. Requires beta

Comparison/Contrast

1.  Dividend growth model good for 2 to 5 year accuracy
2.  Dividend growth model assumes constant growth
3.  CAPM geared for wider assumptions
4.  CAPM involves market-driven variability

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)

Cost of Preferred Stock = Dividend on Preferred/Price of Preferred

=2.93/50=.0586

b. Is there any other method to compute this cost? Explain. (5 pts)

Yes. Weighted Average Cost of Equity

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)

= .6*.5+.1*.25+.3*.25

=.03+.025+.075

=1.3

5. Should the firm use this WACC for all projects? Explain and provide examples as appropriate. (10 pts)

Yes. It is accurate because it divides up common and preferred equity as well as retained earnings. It is especially applicable when determining whether the future value of a project will be profitable.