TASK 4- Capital Budgeting for a New Machine
AirJet best Parts, Inc. should accept this project because because of its
positive NPV and its IRR that exceeds the 15% required rate of return
Depreciation has a tax shield effect (= tax rate x deprecation). To reach
income before tax, depreciation must be subtracted. This figure is then
multiplied by the current tax rate, which is then added back to the same
figure to determine the net income. However, the tax is then added back
to the income because it is a non-cash item to determine the free cash
SUNK COST- AirJet Best Parts Inc.’s expenditure of $100,000 on research
to determine if the machine would improve the productivity of the
organization. This is a past expenditure that cannot be taken into
consideration when determining whether to purchase the machine.
OPPORTUNITY COST- The benefit of increased productivity, and
essentially additional income, that would not be realized if AirJet Best
Parts Inc. does not invest in the machine.
EROSION- The decline in demand of AirJet best Parts Inc.’s other product
offerings as a result of the increased demand of the special component,
which would be produced on the new machine.
SCENARIO ANALYSIS- AirJet Best Parts Inc. would need to estimate their
sales in multiple scenarios including: an optimistic, a normal, and a
pessimistic scenario. After sales are estimated, the company will need to
calculate the cash flow, NPV, IRR for each scenario.
SENSITIVITY ANALYSIS- AirJet best Parts Inc. needs to identify the risk
factors. This can be done by chainging one factor by 1% while keeping all
other factors the same to see the resulting changes in the NPV and IRR.
PROJECT SPECIFIC RISKS- Will the new machine meet the estimated
increases in production? Is there appropriate financing for the machine?
MARKET RISKS- Is there enough demand in the market to justify the
increased in production of the special component?
TASK 5- Cost of Capital
Using a bond from Raytheon at 7% as a benchmark, the following would be true:
Yield to Maturity-
After-Tax Cost of Debt-
AirJet Best Parts Inc.’s cost of debt could have been found by looking at the YTM on
debt the company previously issued, or by looking at the YTM of a competitor with
a similar credit rating.
The YTM should be used as it is the return a bond can yield over its lifetime. A
coupon rate, on the other hand, determines the interest paid out each period. The
YTM is more a more realistic figure than the coupon rate, as the coupon rate is often
inflated to compensate for the addition cost when a bond is issued at a premium.
Risk free rate
COST OF COMMON EQUITY-
ADVANTAGES OF CAPM- CAPM specifically makes adjustments for systematic risk,
or the market risk premium. This is applicable to all companies as long as beta can
DISADVANTAGES OF CAPM- The market risk premium can be difficult to estimate
as it changes over time. It is also difficult to estimate beta which also changes over
time. Additionally, the CAPM uses past data to predict future numbers.
COST OF PREFERRED EQUITY-
No, this is the only method of computing the cost of preferred equity.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)-
The WACC should not be used for all projects. Rather, it should only be used when
the project is of the same risk as the company’s current operation. If the project is
not of the same risk, the discount should be adjusted. In general, the higher the risk
is , the higher the discount rate should be. Furthermore, it is important to note that
various departments within an organization can also have different discount rates
which need to be applied.
NET PRESENT VALUE (NPV)-
Yes, I still stand by my eariler recommendation of purchasing the machine. This
recommendation is based on the positive NPV, which is even higher than
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