Flotation Costs &

NPV
Should we adjust WACC upward to reflect flotation cocst?
•Not the best approach. The required return on an investment depends on the risk of the investment, not the source of the funds
•Instead, we adjust the initial costs of the project upward!
Project’s NPV hoes down
Project’s NPV hoes down

Flotation Costs - cost of issuing new equity

and/or new debt
Should we adjust WACC upward to reflect flotation cocst?
•Not the best approach. The required return on an investment depends on the risk of the investment, not the source of the funds
•Instead, we adjust the initial costs of the project upward!
Project’s NPV hoes down
Project’s NPV hoes down

Should we adjust WACC upward to reflect flotation costs?

 Not the best approach. The required return on an investment
depends on the risk of the investment, not the source of the
funds
 Instead, we adjust the initial costs of the project upward!
Project’s NPV goes down
Problem Nr. 22
Flotation Costs and NPV Photochronograph Corporation (PC) manufactures
time series photographic equipment. It is currently at its target debt-equity ratio
of .70. It’s considering building a new $45 million manufacturing facility. This new
plant is expected to generate aftertax cash flows of $6.2 million a year in
perpetuity. The company raises all equity from outside financing. There are three
financing options:
1. A new issue of common stock: The flotation costs of the new common stock
would be 8 percent of the amount raised. The required return on the company’s
new equity is 14 percent.
2. A new issue of 20-year bonds: The flotation costs of the new bonds would be 4
percent of the proceeds. If the company issues these new bonds at annual
coupon rate of 8 percent, they will sell at par.
Problem Nr. 22
3. Increased use of accounts payable financing: Because this financing is part of
the company’s ongoing daily business, it has no flotation costs, and the company
assigns it a cost that is the same as the overall firm WACC. Management has a
target ratio of accounts payable to long-term debt of .20. (Assume there is no
difference between the pretax and aftertax accounts payable cost.)

What is the NPV of the new plant? Assume that PC has a 35 percent tax rate.
Given:
building a new $45 million manufacturing facility
target debt-equity ratio = 0.70
aftertax cash flows = $6.2 million a year in perpetuity
flotation costs of the new common stock = 8 percent
new equity = 14 percent
flotation costs of the new bonds = 4 percent
annual coupon rate = 8 percent
accounts payable to long-term debt = 0.20
tax rate = 35 percent
Weight of Equity (We) = 1___ = 1____ = 0.588
1+D/E 1 + 0.70

Weight of Debt (Wd) = D/E__ = __0.70__ = 0.412

1+D/E 1 + 0.70

Weight of Accounts Payable (WAP) = Accounts payable_ = __0.20__ = 0.167

1+Accounts payable 1 + 0.20

Weight of Long-Term Debt (WLTD) = ­________1_________ = ___1___ = 0.833

1+Accounts payable 1 + 0.20
Weighted Average Costs of Capital (WACC):

RWACC = (We x Re) + Wd [(WAP x RWACC) + WLTD x Rd x (1 – t)

= (0.588 x 0.14) + (0.412) (0.167RWACC) + (0.833 x 0.08 x (1-0.35)

RWACC = 0.082 + 0.069RWACC + 0.012

0.931RWACC = 0.094

RWACC = 0.101 or 10.1%

Weighted Average Flotation Costs:

FC = (We x Fe) + Wd [(WAP x FAP) + WLTD x Rd)

FC = (0.588 x 0.08) + 0.412 ( 0.167 x 0) + (0.833) (0.04)
= 0.047 + 0 + 0.014
FC = 0.061 or 6.1%
Amount that needs to be raised :

Amount that needs to be raised = Initial investment that’s required

(1 – overall flotation costs)

= ___$45,000,000_____
(1 – 0.061)

Amount that needs to be raised = $47,923,322.68

Net Present Value:
Since the cash flows go to perpetuity;

NPV = (Cashflows)^20 - Amount that needs to be raised

1 + RWACC

NPV = ($6,200,000)^20 - $47,923,322.68

1 + 0.101

NPV = $7.756 million