Flotation Costs and NPV

To illustrate how flotation costs can be included in an NPV analysis, suppose the Triple-day Printing Company is currently at its target debt-equity ratio of 100 percent. It is considering building a new $500,000 printing plant in Kansas. This new plant is expected to generate aftertax cash flows of $73,150 per year forever. The tax rate is 34 percent. There are two financing options:

1. A $500,000 new issue of common stock. The issuance costs of the new common stock would be about 10 percent of the amount raised. The required return on the company's new equity is 20 percent.

2. A $500,000 issue of 30-year bonds. The issuance costs of the new debt would be 2 percent of the proceeds. The company can raise new debt at 10 percent.

Ross et al.: Fundamentals I VI. Cost of Capital and I 15. Cost of Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

Edition, Alternate Edition Policy

516 PART SIX Cost of Capital and Long-Term Financial Policy

What is the NPV of the new printing plant?

To begin, because printing is the company's main line of business, we will use the company's weighted average cost of capital to value the new printing plant:

WACC = (E/V) X Re + (D/V) X Rd X (1 - TC) = .50 X 20% + .50 X 10% X (1 - .34) = 13.3%

Because the cash flows are $73,150 per year forever, the PV of the cash flows at 13.3 percent per year is:

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