Question

Modular Mould Ltd’s capital structure currently comprises 40% debt and 60% equity, a combination which management deems to be optimal and hopes to maintain. Management is currently considering a $2 million expansion of its existing business, which is expected to generate a perpetual cash inflow of $220,000 in future. The prospects of this expansion look good and management is seriously looking at financing options for this expansion.

The first option is a $2 million issue of new equity. The flotation cost of new equity is estimated to be around 5% of the amount raised. The alternative option is a $2 million issue of a 20-year bond. The flotation cost of a new bond issuance is estimated to be around 2% of the amount raised. The corporate tax rate for Modular Mould Ltd is 21%.

Abe Todd, a senior project manager, estimates that the required return on the company’s equity is 12%, and argues that the flotation cost of new equity would increase the cost of new equity to 17%. On this basis, the project does not seem viable. On the other hand, he points out that the company can issue new debt with a 6.8% yield, which would make the cost of new debt 8.8%. He thus recommends embarking on the expansion plans using the proceeds from a bond issuance rather than new equity issues.

Determine if Abe Todd is correct in his assessment of the cost of capital.

Analyse how you would evaluate the project and the cost of capital.

Answer 1