You will assume that you still work as a financial analyst for AirJet Best Parts, 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 15% (Task 4) and (2) the firm’s cost of capital (Task 5).
Task 4. Capital Budgeting for a New Machine
A few months have now passed and AirJet Best Parts, 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 $1,450,000
Year 3 $1,300,000
Year 4 $950,000
You have now been tasked with …show more content…
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%.
e. What is the cost of common equity? (5 pts)
Answer: The cost of common equity is the annual rate of return that an investor expects to earn when investing in shares of a company.
Lockheed Martin (LMT) = beta 0.70 as of 04/04/2012 @ 11:30 AM EDT
Boeing (BA) =beta 1.14 as of 04/04/2012 @ 11:32 AM EDT
Northrop Grumman (NOC) = beta 1.04 as of 04/04/2012 @ 11:36 AM EDT
0.04*0.96=0.384 or 3.84% + 3=6.84%
f. 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)
Answer: Advantages of using the CAPM model as the method to compute the cost of common equity is that it eliminates unsystematic risks. This makes the formula a very simple approach to use. Also, CAPM can lead to better investment decisions compared to other methods. CAPM is