EX Firm X currently has debt of 1000 yielding 10 and Equity

EX. Firm X currently has debt of 1,000 yielding 10% and Equity of 3,000. Company tax rate is 40%. The stock is expected to pay a dividend of $2 next year, which is expected to grow at a constant rate of 10%. Current stock price is $20. Firm is considering expanding its business by investing in a new project that requires initial investments of 2,000. Firm has no cash on hand and needs to issue new stock, with a flotation cost of 20%, to raise the required capital. Suppose the new project will generate a return of 18%, should the firm invest in the project?

Solution

cost of equity with floattation costs = 2/20*(1-0.20) + 10% = 22.50%

since the rate of return is lower than the cost if should not invest