Question

The Rockettech Corp. is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year in perpetuity. The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1.5%. Rockettech’s financial manager, estimates that the required return on the company’s equity is 14%, but argues that the flotation costs increase the cost of new equity to 19%. On this basis, the project does not appear viable. On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt 8.5%. She therefore recommends that Rockettech should go ahead with the project and finance it with an issue of long-term debt.

Is the financial manager right? How would you evaluate the project, considering that the project has the same business risk as the firms other assets?

Answer 1

Finance manager is not right in his calculation of cost of debt and cost of equity. She is also not right in the decision of choosing debt financing because firm has already achieved its target debt ratio of 40%. Therefore firm should use mix of debt and equity in the ratio of 2:3.