Flotation Costs 14.6 LO4 The required return depends on the risk, not how the money is raised However, the cost of issuing new securities should not just.

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Flotation Costs 14.6 LO4 The required return depends on the risk, not how the money is raised However, the cost of issuing new securities should not just be ignored either Basic Approach Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term

NPV and Flotation Costs - Example Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $250,000 per year for 7 years. The WACC is 15% and the firm’s target D/E ratio is .6 The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs? D/E = .6; Let E = 1; then D = .6 V = .6 + 1 = 1.6 D/V = .6 / 1.6 = .375; E/V = 1/1.6 = .625 PMT = 250,000; N = 7; I/y = 15; CPT PV = 1,040,105

NPV and Flotation Costs – Example continued D/E = 0.6 – therefore, D/V = 6/16 = 0.375 and E/V = 10/16 = 0.625 fA = (.375)(3%) + (.625)(5%) = 4.25% True cost is $1 million / (1-0.0425) = $1,044,386 PV of future cash flows = 1,040,105 NPV = 1,040,105 – 1,044,386 = -4,281 The project would have a positive NPV of 40,105 without considering flotation costs Once we consider the cost of issuing new securities, the NPV becomes negative