Solution to Case 23

Evaluating Project Risk

It’s Better to Be Safe Than Sorry!

Questions:

1. What seems to be wrong with the way the NPV of each project has been calculated? Indicate without any calculations, how Pete and John should go about recalculating the projects’ NPVs.

The NPV of each project has been calculated by discounting the cash flows at the 8% before-tax cost of debt. This is incorrect. Since the company has debt, preferred stock and common stock in its capital structure the weighted average cost of capital must be calculated and used to discount the projects’ cash flows. The weight of each component of the target capital structure (based on market values of outstanding securities)
($1,176,000/.625), without having to issue new equity, and still maintain its target capital structure. Beyond a capital requirement of $1,881,600, the marginal cost of capital will increase primarily due to the higher cost of new equity.

5. Develop the Marginal Cost of Capital for the intended capital investments. Explain how the values are arrived at.

Cost of New Equity

Under DDM…..

= [D0(1+g)/(P0 – Flotation Cost)] + g

= [= .51(1.12) / ($25 - .15*$25) + .12 = .57/(25-3.75) + .12 = 14.68%

Flotation Cost Adjustment

= Cost of New Equity under DDM (with flotation cost) – Cost of Retained Earnings under DDM (without flotation cost) = 14.68% – 14.28% = 0.4%

Average Cost of New Equity

= Average Cost of Retained Earnings + Flotation Cost Adjustment

=15.54%+0.4% = 15.94%

Marginal Cost of Capital

$0 -