3 Cost of new equity issuing new stock requires loatations p

3. Cost of new equity: issuing new stock requires \"loatations proceeds. % of isaing Adjusting for net share price receivedDiv yielding 0% and Equity o 3,000 Company ax r, which is expected EX. F?mX currentlyhasdebto rate 40%) The stock is expected to pay a dividend(ES2 to grow at a constant rate of 10% CurrentstockpricelS20 Firm is considering expanding its business by inv 000 Firm has no cash on hand and needs to issue new stock, with a flotation cos esting in a new project that requires initial investments of 8% raise the required capital. Suppose the new project will generate a return to should the firm invest in the project?

Solution

Before tax cost of debt = 10%

After tax cost of debt = 0.1 ( 1 - 0.4)

After tax cost of debt = 0.06 or 6%

Cost of equity = [ D1 / share price ( 1 - flotation cost)] + growth rate

Cost of equity = [ 2 / 20( 1 - 0.2)] + 0.1

Cost of equity = 0.225 or 22.5%

WACC = Weight of debt * cost of debt + weight of equity * cost of equity

WACC = ( 1000 / 4000) * 0.06 + ( 3000 / 4000) * 0.225

WACC = 0.015 + 0.16875

WACC = 0.18375 or 18.375%

Since cost of capital of 18.375% is greater than return of 18%, firm should NOT invest in the project.