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Task 5: Cost of Capital

AirJet Best Parts Inc. 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 Best Parts Inc. is considering issuing new bonds and has decided to use Caterpillar

(CAT) as a comparison company.

a. What is the YTM of the comparison company%u2019s 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 Best Parts Inc. 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 35%? (5 pts)

c. Explain what other methods you could have used to find the cost of debt for AirJet Best

Parts Inc.(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 Caterpillar an

appropriate comparison company. You may obtain the betas from Yahoo or Google Finance. Assume the risk free rate to be 1.75% and the market risk premium to be

6%.

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

$2.50 and the current value of the stock is $43.50 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 65% 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. (10 pts)

6. Recompute the net present value of the project based on AirJet Parts%u2019 cost of capital

that you just calculated. Do you still believe that your earlier recommendation for accepting or rejecting the project was adequate? Why or why not? (5

pts)

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