Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%.
Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?
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Project 1 NPV |
Project 2 NPV |
The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the project by a fixed percentage that does not necessarily reflect the present value of the flotation costs. The impact on project evaluation depends on the length of the project and magnitude of the flotation costs, however, for most projects that are shorter, the incorrect method will overstate NPV, and that is exactly what we see in this problem.
Correct method of accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50%
WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55%
Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000
Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000
NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535) = $117,535
NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823) = $31,823
Incorrect Adjustment for cost of equity method for accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69%
WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65%
NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) = $120,327
NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523
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发表于 2010-4-21 10:42
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