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%.

1. Calculate the cost of capital.
2. Calculate the flotation cost.
3. Calculate the initial investment.
4. Calculate the NPV for the project after adjusting for flotation costs.
5. What do you conclude?

Answer 1

.aCalculate the cost of capital.

Debt Equity Ratio=0.5

Debt=0.5*(Equity)

Total Capital =(Debt)+(Equity)=1.5*(Equity)

Wd=Weight of Debt =0.5*(Equity)/1.5*(Equity)=0.5/1.5=0.3333

We=Weight of Equity =1/1.5=0.6667

Ce=Cost of Equity =15/(1-0.1)=16.67%

Before tax Cost of Debt=10/(1-0.05)=10.53%

Cd=After tax cost of Debt=10.53*(1-Tax Rate)=10.53*(1-0.34)=6.95%

Cost of Capital=Weighted average cost =Wd*Cd+We*Ce=0.3333*6.95+0.6667*16.67=13.43%

Cost of Capital

13.43%

.b.Calculate the flotation cost:

Total Capital=$50,000

Debt =0.3333*50000=$16667

Equity =0.6667*50000=$33333

Flotation cost of Equity =33333*10%=$3333

Flotation cost of Debt=5%*16667=$833

Total flotation Cost=3333+833=4166

Flotation Cost

$4,166

c.Calculate the initial investment.

Initial Investment =$50000+4166=$54,166

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

Discount rate =cost of capital=13.43%=0.1343

Present value of after tax cash flow=10000/0.1343=$74,477

Initial Investmet =$54,166

NPV=74477-54166=$20,311

e.CONCLUSION:

NPV is positive.

Project is acceptable