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Which of the following about flotation costs is least correct? Increase the WACC for the project...

  1. Which of the following about flotation costs is least correct?
    1. Increase the WACC for the project
    2. Decrease the NPV of the project
    3. Increase the initial cost of the investment
  2. The discount rate used in capital budgeting should equal the
    1. Weighted average cost of capital
    2. Market rate of return
    3. A risk adjusted weighted average cost of capital

Solutions

Expert Solution

Which of the following about flotation costs is least correct?

c.Increase the initial cost of the investment

Initial costs of the investment are independent of the flotation costs since flotation costs are costs that are incurred when a company issues new securities.

a. Increase the WACC for the project - This statement is correct as flotation costs are incurred while issuing new securities. These costs will increase the firm's cost of capital

b.Decrease the NPV of the project - This statement is correct as if the flotation costs are considered as initial cash-flow, then it may decrease the NPV of the project. Even if flotation costs are considered while calculating WACC, they will increase the cost of capital, thus reducing the NPV

This statement is least correct. A firm's WACC depends on its capital structure and the signifies the overall cost of capital that

The discount rate used in capital budgeting should equal the

a) Weighted average cost of capital

The WACC is the weighted average cost of capital and signifies the cost at which the firm's capital is raised. Hence for any project, the cash-flows are discounted by WACC and analyzed if the NPV is positive or not. This rate is the minimum barrier that a new project return should cross in order to be viable.

Market rate of return - This has nothing to do with calculation of NPV as this does not signify the company's costs

A risk-adjusted weighted average cost of capital - A company raises capital at WACC and not the risk-adjusted WACC and hence requires a rate of return higher than the WACC and hence the same is used to discount csh-flows while calculating NPV

jeff jeffy answered 2 years ago
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