In an IPO, NeoDiagnostic sold 10,000 shares for $35 each, but all the money exce
ID: 2719315 • Letter: I
Question
In an IPO, NeoDiagnostic sold 10,000 shares for $35 each, but all the money except for $100,000 was subsequently spent on an R&D; project. NeoDiagnostic Inc therefore currently has $100,000 cash on hand and, so far as investors know, no other assets. NeoDiagnostic announces that the R&D; project yielded a newly obtained patent that the firm wants to exploit in a new manufacturing operation. NeoDiagnostic has determined that it will need to invest $525,000 to move into the manufacturing phase for its new product. It intends to raise some of the new funds it will need by borrowing $200,000 at an interest rate of 6% per annum. The debt will be retired in full at the conclusion of the project in 11 years from now. Assume that the corporate tax effect of debt approximates the overall effect of debt on firm market value. Remaining funds needed for the investment will be raised through a new equity issue.Explanation / Answer
Cost of equity is 0.0325 + 2.19(0.0525-0.0325) X 100 = 7.63%
Cost of debt is 0.06(1-0.34) =3.96%
Total funds needed for new project is $ 525,000,
Sources of fund: Cash in hand $ 100,000, Debt $ 200,000 Equity $225,000
Total equity issued by the company = 350,000 + 225,000 = $ 575,000
Computation of WACC:
Therefore, the overall cost of capital is 6.68 %
b) The market will react favorably, and the stock price will go up, as the cost of capital has come down because of introduction of debt in the capital structure.
c) At a par value of $ 35 per share, the company would need to float 6429 shares to mobilize $225,000
Source of capital Amount Weights Specific cost Weighted average cost Equity 575,000 0.742 0.0763 0.0566 Debt 200,000 0.258 0.0396 0.0102 1.000 0.0668Related Questions
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