Capital Budgeting Example

*A proposed drone investment project for AJ-Securities has an equipment cost of $3,750,000. The cost will be depreciated straight-line to a zero salvage value over its 30 year life. The firm will also use existing equipment that has been fully depreciated but has a market value of $600,000 at the end-of-life for the project.

*The price of the drone service per customer is $3,550 a year but expect price to increase by 2.3% each year. The number of customers is expected to stay constant throughout the project life at 6,200.

*Variable costs will run $1,800 per customer per year, and expected to increase at a 1.8% rate per year.

*Fixed cost are expected to be $926,100 per year.

*The firm will also need to invest $8,500 in net working capital for the next seven years, and then increase by $10,600 in year eight and remain at this level for the life of the project.

*Marketing research for this project cost $352,500 last year, and on-going marketing ads will cost $81,200 per year.

* The risk of this drone project is different than the overall firm. Firms that only develop drone projects are: (1) Drone City that has a beta of 3.2 with Debt to Equity ratio (D/E) of 2; SS Service that has a beta of 2.7 with a (D/E) of 1.5; New Wave Securities with a beta of 2.5 and a (D/E) of 1.

*The current capital structure is: debt of 500,000 bonds at a price of $980 each with semi-annual compounding for thirty years; 1,550,000 shares of common stock currently trading for $36 per share; and Preferred Stock of 800,000 shares selling for $46 a share with annual dividends of $2.75. The coupon rate on the bonds is 6%. Next year, the firm will change the capital structure to 40% debt, 50% common stock, and 10% preferred stock.

*The US T-bill rate is 2.9%, the beta for AJ-Securities is 2.2, and the current return to the S&P500 is 12%. The corporate marginal tax rate is 33% while the average tax rate is 28%.

(A.) What are the cash flows from assets for the project?

(B.)What is the cost of equity for this project?

(C.) What is the cost of debt for this project?

(D.) What is the cost of capital for this project?

(E.) What is the NPV of this project?

(F.) What is the Payback Period?

(G.) What is the Profitability Index?

(H.) What is the IRR?

(I.) Should you accept or reject this project? Assume the payback cutoff is 4 years.