1. Please comment on the following suggested approach. Is it helpful and how?
A firm's overall WACC is a market value weighted average of the after?tax cost of debt and cost of equity:
RWACC = [B/(B+S)]RB(1 - TC) + [S/(B + S)]RS
B = $5,000,000
S = $6,700,000
RB = 10%
RS = 24.925%
TC = 34%
RWACC = (5,000,000/11,700,000)(.10)(.64) + (6,700,000/11,700,000)(.24925) = 17.094%
It is important to KEEP IN MIND that the firm's WACC is only appropriate as a discount rate for a project when:
1. The project has similar systematic business risk as the firm.
2. The project and firm have the same debt capacity.
That is, the WACC formula gives the right discount rate only for projects that have the same asset and liability mix as the firm, such as a scale?enhancing expansion of existing firm assets. In practice, a project's systematic business risk may be different from that of the firm. A project's debt capacity can also be different than the average debt capacity of the firm. Each project should be treated as if it were a mini?firm, with its own proportion of debt and equity and its own capital costs.
2.When a company raises funds through external debt or equity, it must incur flotation costs. Assume that the municipal government no longer sponsored the project and PPM, Inc. must obtain $5,000,000 with new debt at the market interest rate of 10%.
Flotation costs are 12.5% of gross proceeds.
Since the company must have $5,000,000 in net proceed, it must raise $5,000,000/(1 -0.125) = $5,714,286.
The $714,286 flotation cost is a cash expense today.
The U.S. tax code allows this expense to be amortized over five years, resulting in a ($714,286/5 years) = $142,857 deduction per year. Annual tax shields from amortization of the flotation costs are (.34)($142,857) = $48,571. The net present value of the after?tax flotation cost is:
NPV(flotation cost) = -$714,286 + $48,571 × [1 - (1/1.1)5]/.1 = -$714,286 + $184,124 = -$530,162
In your own words, how would you explain the impact of flotation cost of the proposed initiative to the founder who is not fluent in corporate finance?