Question

Cherry Creek Inc. is considering expanding to another city; the project will cost $50,000 and is expected to generate after-tax cash flows of $10,000 per year in perpetuity.

The firm has a target debt/equity ratio of 0.5 and the new equity has a flotation cost of 10% and a required return of 15%, while new debt has a flotation cost of 5% and a required return of 10%. The tax rate is 34%.

a. Calculate the cost of capital.

b. Calculate the flotation cost.

c. Calculate the initial investment.

d. Calculate the NPV for the project after adjusting for flotation costs.

e. What do you conclude?

Answer 1

Total investment required = $ 50,000

Debt/ equity ratio = 0.5

Let Debt Investment be a

Thus, Equity investment = 2a

Flotation cost

Debt = 5%

Equity = 10%

[2a × (1-0.10)] + [a × (1-0.05)] = 50,000

a = 18,182

Debt to be raised = $ 18,182

Equity to be raised = $ 36,364

Total capital = 54,546

Cost of debt = 10 × (1-0.34) = 6.6%

Cost of equity = 15%

Cost of capital

=( 36,364 × 0.15) + ( 18,182 × 0.066)/ 54,546

= 0.122

a. Cost of capital = 12.2%

b. Flotation cost

Debt = 18,182 × 5% = $ 909

Equity = 36,364 × 10% = $ 3,637

Total = 877 + 3,704 = $ 4,546

c. Initial investment

= 50,000 + 909 + 3,637 = $ 54,546

d. Calculation of NPV

PV of outflows = 54,546

PV of inflows = 10,000/0.122 = 81,967

NPV = - 54,546 + 81,967 = $ 27,421

​​​​​​e. Since NPV is positive , project is profitable