Reference no: EM133033125

Question - Southwest 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. Southwest 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 Southwest 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.

Southwest 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%.

Required -

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?

5. What is the proposed annual depreciation on the asset?

6. What is the project's after tax salvage in Year 3?

7. What are the total cash flows in each Year 0, Year 1, Year 2, and Year 3?

8. Advise Southwest 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. Southwest 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 Southwest and why?

11. Southwest 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 Southwest and why?