Question

Cal Poly Corporation would like to start a new project: building a high-tech rose float for the next regional contest. This rose float project will require $35,000 in the initial cost. The company is planning to raise this amount of money by selling new corporate bonds and new stocks. It has a target capital structure of 60 percent common stock, and 40 percent debt. Flotation costs for issuing new common stock is 7%, and for new debt it is 4%.

(a) The true required initial investment that Cal Poly Corporation should use in its valuation of the rose is:_____.
1. $36,920.
2. $36,820.
3. $35,000.
4. $33,180.
(b) The lower the flotation costs, the lower the initial investment that needs to be used in project valuation, and so the lower the project's Net Present Value. This statement is____.
1. True
2. False

Answer 1

To calculate the true required initial investment, we need to take into account the flotation costs for issuing new common stock and new debt. The correct answer is $36,920. The statement that lower flotation costs result in a lower Net Present Value is false.

Step-by-step explanation:

To calculate the true required initial investment, we need to take into account the flotation costs for issuing new common stock and new debt. The target capital structure is 60% common stock, so the initial cost of issuing new common stock would be $35,000 + 7% of $35,000. The flotation costs for new debt is 4% of $35,000. Adding these costs together gives us the true required initial investment of $36,920, so the correct answer is (1) $36,920.

The statement that lower flotation costs result in a lower initial investment and lower Net Present Value is false. Flotation costs do not directly impact the project's Net Present Value. Net Present Value is determined by the cash flows generated by the project and the required rate of return. Flotation costs only affect the initial investment, not the project's profitability. Therefore, the correct answer is (2) False.

Answer 2

Answer and Explanation:

The computation is shown below;

a.

Given that

Weight of Equity = 0.4

Weight of Debt = 0.6

The Flotation cost of Capital = Weight of Equity × Flotation cost of Equity + Weight of Debt × Flotation cost of Debt

= 7 × 0.4 + 4 × 0.6

= 5.2

Now

True cost is

= initial investment ÷ (1 - flotation cost %)

= $35,000 ÷ (1 - 0.052)

= $36,920

b

In the case when there is a less flotation cost so it would decreased the initial investment due to this there would be an increase in net present value

hence, the given statement is false