NPV problem

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NPV problem

Postby aroranidhi2004 » Wed Nov 12, 2014 6:26 am

Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%.Â

Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?

Project 1 NPV Project 2 NPV

A) Understated Overstated

B) Understated Understated

C) Overstated Overstated

My question is, when we are using incorrect method of distributing the floatation cost to our discount rate throughout the project than how come the NPV will be overstated in this case. Because if the discount rate increases than NPV should be less not more. Please help with this.


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NPV problem

Postby edupristine » Wed Nov 12, 2014 8:30 am

Hi nidhi,

Please note that if the floatation costs are adjusted into the cost of equity (which is the incorrect method btw), then the floatation costs are distributed over the entire life of the project.

This method spreads the flotation cost out over the life of the project by a fixed percentage that does not necessarily reflect the present value of the flotation costs.

Hence the discount rate would be comparatively lower because of the spread in floatation costs over the entire life. Lower discount rate implies overstated NPV.

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