Your company is considering a project that will cost $100. The project will generate after-tax cash flows of $37.50 per year for five years. The WACC is 10% and the firm's D/A ratio is .35. The flotation cost for equity is 5%, the flotation cost for debt is 2%, and your firm does not plan on issuing any preferred stock within its capital structure. If your firm follows the practice of incorporating flotation costs into the project's initial investment, what is the weighted-average flotation cost for the firm?

Question

Quizplus · Accepted Answer

First, we need to calculate the initial investment required for the project by taking flotation costs into account.

Equity flotation cost = 5%
Debt flotation cost = 2%
Weighted-average flotation cost = (0.35 x 0.05) + (0.65 x 0.02) = 0.0365 or 3.65%

Initial investment = $100 + ($100 x 3.65%) = $103.65

Next, we calculate the NPV of the project using the after-tax cash flows and WACC:

NPV = (37.5 x (1 - 0.4)) / 0.1 x (1 - (1 + 0.1)^-5) - $103.65
NPV = $6.79

Since the NPV is positive, the project should be accepted.

Therefore, the weighted-average flotation cost for the firm is 3.65%. The closest answer choice is C: 3.95%.

Your Company Is Considering a Project That Will Cost $100