Reference no: EM132956781

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%.

Problem 1: What is the project's after-tax cost of debt?

Problem 2: What is the project's cost of preferred stock?

Problem 3: What is the project's cost of common equity?

Problem 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)

Problem 5: What is the proposed annual depreciation on the asset?