Homework 8: Flotation Costs and NPV (Q) FP\'s target debt-equity ratio is .55. I

Question

Homework 8: Flotation Costs and NPV (Q) FP's target debt-equity ratio is .55. It's considering building a new $50M plant which is expected to generate aftertax cash flows of $6.7M a year in perpetuity. FP raises all equity from outside financing. There are three financing options A new issue of common stock: The flotation costs of the new common stock would be 8 percent of the amount raised. The required return on the company's new equity is 14 percent. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4 percent of the proceeds. If the company issues these new bonds at an annual coupon rate of 8 percent, they will sell at par. Increased use of accounts payable financing: Because this financing is part of the company's ongoing daily business, it has no flotation costs and the company assigns it a cost that is the same as the overall firm WACC. Management has a target ratio of accounts payable to long-term debt of .20. (Assume there is no difference between the pretax and aftertax accounts payable cost.) What is the NPV of this project? 47

Explanation / Answer

Assuming 35% tax rate

D/E = 0.55

D/V = 0.55 / 1.55 = 0.35

E/V = 1 - 0.35 = 0.65

WACC = 0.65*14% + 0.35*((0.2/1.2)*WACC + (1/1.2)*8%*(1-35%))

0.94086*WACC = 0.105699

WACC = 0.105699 / 0.94086 = 11.23%

Flotation costs = 0.65*8% + 0.35*((0.2/1.2)*0+ (1/1.2)*4%) = 6.34%

NPV = -50 / (1-6.34%) + 6.7/11.23% = 6.25 M $

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