Question

You are a financial manager for Lenzie Corporation. The firm needs to purchase equipment for its new production plant. The total cost of the equipment is $1,500,000. It is estimated that the after-tax cash inflows from the project will be $710,000 annually for five years. Lenzie Corporation has a market value debt-to-assets ratio of 40%. The firm’s common stock has a beta of 1.85, the risk-free rate is 1.2%, and the expected return on the market portfolio is 7%. The firm's pre-tax cost of debt is 7%, and the flotation costs of equity and debt are 7% and 4%, respectively. The tax rate is 36%. Assume the project is of similar risk to the firm's existing operations.

What is the WACC? What is the Weighted Average Flotation Cost? What is the NPV of the project after adjusting for flotation costs?

Answer 1

1)
Cost of Equity = Rf + Beta x (Rm- Rf)
Cost of Equity = 1.2% + 1.85 x (7%-1.2%)	11.93%
Cost of Debt after tax  = 7% x (1-36%)	4.48%
WACC = 60% x 11.93% + 40% x 4.48%	8.95%
2)
Weighted Average Flotation Cost = (60% x 7%)+(40% x 4%)	5.800%
3)
Total cost of the equipment including flotation costs:
Amount raised(1 – 5.800%) = $1,500,000
Amount raised = $1,500,000/(1-5.8%)	$  1,592,356.69
Year	Cash flow	Discount Rate 8.95%	Present Value
0	$ (1,592,356.69)	1.0000	$ (1,592,356.69)
1	$     710,000.00	0.9179	$     651,675.08
2	$     710,000.00	0.8425	$     598,141.42
3	$     710,000.00	0.7732	$     549,005.44
4	$     710,000.00	0.7097	$     503,905.86
5	$     710,000.00	0.6514	$     462,511.12
		NPV	$  1,172,882.23