Reading 45: Cost of Capital - LOS l ～Q1-2 style, white, black, produce, expected

mayanfang1

 

Q1. Cullen Casket Company is considering a project that requires a $175,000 cash outlay and is expected to produce cash flows of $65,000 per year for the next four years. Cullen’s tax rate is 40% and the before-tax cost of debt is 9%. The current share price for Cullen stock is $32 per share and the expected dividend next year is $1.50 per share. Cullen’s expected growth rate is 5%. Cullen finances the project with 70% newly issued equity and 30% debt, and the flotation costs for equity are 4.5%. What is the dollar amount of the flotation costs attributable to the project, and that is the NPV for the project, assuming that flotation costs are accounted for correctly?

          Dollar amountof floatation costs      NPV of project

 

A)             $7,875                                       $30,510

B)             $5,513                                       $30,510

C)             $5,513                                       $32,872

Q2. 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?

          Project 1 NPV                    Project 2 NPV

 

A)    Understated                       Overstated

B)    Overstated                          Overstated

C)    Understated                       Understated

mayanfang1

答案和详解如下：

Q1. Cullen Casket Company is considering a project that requires a $175,000 cash outlay and is expected to produce cash flows of $65,000 per year for the next four years. Cullen’s tax rate is 40% and the before-tax cost of debt is 9%. The current share price for Cullen stock is $32 per share and the expected dividend next year is $1.50 per share. Cullen’s expected growth rate is 5%. Cullen finances the project with 70% newly issued equity and 30% debt, and the flotation costs for equity are 4.5%. What is the dollar amount of the flotation costs attributable to the project, and that is the NPV for the project, assuming that flotation costs are accounted for correctly?

          Dollar amountof floatation costs      NPV of project

 

A)             $7,875                                       $30,510

B)             $5,513                                       $30,510

C)             $5,513                                       $32,872

Correct answer is C)

In order to determine the discount rate, we need to calculate the WACC.

After-tax cost of debt = 9.0% (1 – 0.40) = 5.40%
Cost of equity = ($1.50 / $32.00) + 0.05 = 0.0469 + 0.05 = 0.0969, or 9.69%
WACC = 0.70(9.69%) + 0.30(5.40%) = 8.40%

Since the project is financed with 70% newly issued equity, the amount of equity capital raised is 0.70 × $175,000 = $122,500

Flotation costs are 4.5 percent, which equates to a dollar flotation cost of $122,500 × 0.045 = $5,512.50.

Q2. 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?

          Project 1 NPV                    Project 2 NPV

 

A)    Understated                       Overstated

B)    Overstated                          Overstated

C)    Understated                       Understated

Correct answer is B)

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 = 0.045 + 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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