Question

(Short Answer – Chapter 13) Downtown Stores is considering a project with an initial investment of $900,000. The present value of the future cash flows of the project is $950,000. The company can issue equity at a flotation cost of 8.76 percent and debt at 5.93 percent. The firm currently has a debt-equity ratio of 0.35. Thirty (30) percent of equity will come from retained earnings (internal sources). What should the firm use as their weighted average flotation cost? If the firm has to invest $900,000 in the project how much money does it have to raise (round to the nearest dollar)? Will the firm invest in the project if (a) there were no flotation costs and (b) there were flotation costs?  Credit will only be given if you provide numerical support for your answers.

Answer 1

Debt to equity ratio = D / E = 0.35

Hence, debt to total capital ratio = Wd = D / (D + E) = 0.35 / (0.35 + 1) =  0.2593

Hence, proportion of equity in total capital = We = 1 - Wd = 1 - 0.2593 =  0.7407

Thirty (30) percent of equity will come from retained earnings (internal sources)

Hence, internal accruals proportion in total capital = Wie = 30% x We = 30% x  0.7407 =  0.2222

External equity proportion in total capital, Wee = 70% x We = 70% x 0.7407 = 0.5185

The company can issue equity at a flotation cost of Fe = 8.76% and debt at Fd = 5.93%

What should the firm use as their weighted average flotation cost?

Weighted average flotation cost = F = Wd x Fd + Wie x 0% + Wee x Fe = 0.2593 x 5.93% + 0.2222 x 0% + 0.5185 x 8.76% = 6.0796%

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If the firm has to invest $900,000 in the project how much money does it have to raise (round to the nearest dollar)?

The money it has to raise = Investment / (1 - F) = $ 900,000 / (1 - 6.0796%) = $  958,259

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Will the firm invest in the project if (a) there were no flotation costs

If there were no flotation cost, funds to be raised = investment = 900,000

NPV = - Initial investment + PV of future cash flows = -900,000 + 950,000 = $ 50,000

Since, the NPV is positive the firm will invest in the project.

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and (b) there were flotation costs?

NPV = - Initial investment + PV of future cash flows = -958,259 + 950,000 = - $ 58,259

Since, the NPV is negative the firm will not invest in the project.