American Airlines is seeking to purchase a major piece of equipment for $1.5 million.It will cost an additional $300,000, to ship and install the equipment.The equipment will result in annual cost savings of $950,000 over the next 3 years.The asset will be fully depreciated on a straight-line basis over the next 3 years.American Airlines then intends to sell the asset at the end of 3 years for $300,000.The equipment purchase is part of a project in which American will invest 10% of the asset's total cost of acquiring the asset in net working capital which will be recovered at the end of 3 years.

American intends to finance the

acquisition of the equipment as follows:

Issue

100,000 common stocks which are currently priced at $8.75 per share.The

company's common stock has a beta of 1.5.

Issue

3,200 6% preferred stock with $100 par value which are currently priced at $125

per share.

The

remainder of the financing will be obtained from the issue of 25-year

semiannual 8% $1,000 par value bonds, that would sell at 105%.

Other

information:

The

company falls within the 20% tax bracket.

The

risk-free rate is 4% and the expected return on the market is 11.5%.

Questions

1.What is

the project's after-tax cost of

debt?

2.What is

the project's cost of preferred

stock?

3.What is

the project's cost of common

equity?

4.What is

the project's weighted average cost of capital? (Hint: ensure the sum of weights is xequal

to 1 if you round your

numbers)

5.What is

the proposed annual depreciation on the

asset?

6.What is

the project's aftertax salvage in Year

3?

7.What are

the total cash flows in each Year 0, Year 1, Year 2, and Year 3?

8.Advise American

Airlines whether it should accept the project if its investment policy is to

only accept projects with a payback period of no more than 2

years.Support your advice by using the most

applicable capital budgeting technique and state the

payback period for this

project.

9.Why would

you not recommend that the

company use the payback period method to decide whether to accept/reject this

project?

10. American Airlines has access to

unlimited financing and is simultaneously

considering another project that is independent of this project, of equal size

and scale as this project, and has a NPV of $578,500.Which project(s)

would you recommend to American and why?

11. American Airlines has access to

unlimited financing and is simultaneously

considering another project that is mutually exclusive to this project, of

equal size and scale as this project, and has an IRR of 25%.Which

project(s) would you recommend to American and

why?