Question

BMI Inc. is considering a project with an initial investment of $1, 100,000. the percent value of the future cash flows of the project is $1,175,000. the company can issue equity at a flotation cost of 9.76 percent and debt at 6.93 percent. the firm currently has a debt-equity ratio of 0.60. the firm is considering two scenarios. first, all funds will be raised externally. second, seventy percent of equity will come from retained earnings (internal sources). what should the firm use as their weighted average flotation cost for the two scenarios? if the firm has to invest $1,100,000 in the project how much money does it have to raise (round to the nearest dollar) in the two scenarios? should the firm invest in the project if (a) there were no flotation costs (b) in the first scenario and (c) in the second scenario? credit will only be given if you provide numerical support for your answers.

please solve this. urgent

Answer 1

As per debt-equity ratio, Debt proportion = 0.6; equity proportion = 1

Weighted average floatation cost for scenario 1 = [(Equity flotation cost*equity proportion)+(Debt flotation cost*debt proportion)]/(equity proportion+debt proportion) = [(9.76%*1)+(6.93%*0.6)]/(1+0.6) = (9.76%+4.158%)/1.6 = 13.928%/1.6 = 8.69875%

Weighted average floatation cost for scenario 2 = [(Equity flotation cost*equity proportion)*external funding+(Debt flotation cost*debt proportion)]/(equity proportion+debt proportion) = [(9.76%*1*0.3)+(6.93%*0.6)]/(1+0.6) = (2.928%+4.158%)/1.6 = 7.086%/1.6 = 4.42875% [Note: No flotation cost for funding internally]

Money has to raise externally in scenario 1 = Money has to invest/(100%-Weighted average flotation cost) = $1,100,000/(100%-8.69875%) = $1,100,000/91.30125% = $1,204,803

Money has to invest from external source for scenario 2 = Money raised through debt+Money raised through issue of equity = ($1,100,000*0.6/1.6)+($1,100,000*1/1.6*0.3) = $412,500+$206,250 = $618,750 (Note:0.3 represent money raised externally i.e, 1-0.7)

Money has to raise externally in scenario 2 = Money has to invest from external source for scenario 2/(100%-Weighted average flotation cost) = $618,750/(100%-4.42875%) = $618,750/95.57125% = $647,423

Part a)

The firm invest in the project if there is no floatation cost because NPV of the project is positive. i.e, present value of the future cashflow-initial investment = $1,175,000-$1,100,000 = $75,000

Part b)

The firm should not invest in this project if the case is scenario 1 because money raised to invest is more than present value of the future cashflow [$1,204,803>$1,100,000]. It gives negative NPV

Part c)

The firm can invest in the project if the case is scenario 2 because it gives positive NPV

Money raised internally = Initial investment*Equity proportion*70%/Total proportion = $1,100,000*1*70%/1.6 = $481,250

Total money raised to invest in the project in scenario 2 = Money raised internally+Money has to raise externally in scenario 2 = $481,250+$647,423 = $1,128,673

NPV = present value of the future cashflow-Total money raised to invest in the project in scenario 2 = $1,175,000-$1,128,673 = $46,327.