When borrowing a constant proportion of the market value of the project, the interest tax shields are as uncertain as the value of the reject, and therefore must be discounted at the project’s opportunity cost of capital. 18. Opportunity cost of capital – Suppose the project described in Problem 17 is to be undertaken by a university, Funds for the project will be withdrawn from the universities endowment, which is invested in a widely diversified portfolio of stocks and bonds. However, the university can also borrow at The university is tax exempt.
The university treasurer proposes to finance the project by issuing $400,000 of perpetual bonds at 7% and by selling $600,000 worth of common stocks from the endowment. The expected return on the common stocks is 10%. He therefore proposes to evaluate the project by discounting at a weighted-average cost of capital, calculated as: What’s right or wrong With the treasurer’s approach? Should the university invest? Should it borrow? Would the projects value to the university change if the treasurer financed the project entirely by selling common stocks from the endowment?
The immediate source of funds (i. E. , both the proportion borrowed and the expected return on the stocks sold) is irrelevant. The project would not be any ore valuable fifth university sold stocks offering a lower return. If borrowing is a zero-NP activity for a tax-exempt university, then base-case NP equals APP, and the adjusted cost of capital r* equals the opportunity cost of capital with all-equity financing. Here, base-case NP is negative; the university should not invest.
1 Issue cost and APP – The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year n perpetuity. The company is uncertain whether to undertake this expansion and how to finance it.
The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs Of a debt issue would be around 139%.
Bunge’s financial manager, Ms. Poly Ethylene, estimates that the required return on the company’s equity is 14%, but she argues that the flotation costs increase the cost Of new equity to 19%. On this basis, the project does not appear viable. On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt She therefore recommends that Bunsen should go ahead with the project and finance it with an issue of long-term debt. Is Ms.
Ethylene right? How would you evaluate the project? Note the following: The costs of debt and equity are not and 19%, respectively, These figures assume the issue costs are paid every year, not just at issue. The tact that Bunsen can finance the entire cost of the project with debt is irrelevant. The cost of capital does not depend on the immediate source offends; what matters is he project’s contribution to the firm’s overall borrowing power, The project is expected to support debt in perpetuity.