SAINT MARY’S UNIVERSITY
FINANCE, INFORMATION SYSTEMS, & MANAGEMENT SCIENCE
DUE FRIDAY, Feb. 4
by 12:00 noon
A firm is going to finance a new project 100 percent with debt, through a new bond issue.
the firm is only using debt to finance the project, the NPV of the project should be calculated
using the cost of debt as the discount rate.
Is this statement true, false, or uncertain?
The statement is false.
The cost of capital for a new project depends on the use of funds, not the
Even if this particular project will be funded with debt, it is probably only one of many
projects that the firm undertakes.
The firm, over time, will raise financing through a number of
sources, including internal funds, new equity, new preferred shares, and new debt.
The source of
funding for this project is from the pool of available funds.
Therefore the cost of capital for the
project should be the WACC if the project has the same risk as the overall company, otherwise
we should calculate the divisional WACC to accurately reflect the risk of the division.
The little company you and your friend started in your parents’ garage has grown so much that
you are now ready to take the firm public. In your discussions with one of the top investment
dealers, you have been given a choice between two alternatives:
: The investment dealer will underwrite the issue of 1 million shares at $14 per share. There will
be an underwriting fee of 6.5 percent of the gross proceeds.
: The investment dealer will accept the securities on a “best efforts” basis. The price will be $15
per share, and it is believed that 95 percent of the shares will be sold. The investment dealer’s fee
will be $950,000.
What will the net proceeds be under each plan? Which plan should you accept?
Under Plan I
, you will gross $14 x 1 million shares = $14 million and will pay $14 million x
0.065 = $910,000 in fees. The net proceeds are therefore $13,090,000.
Under Plan II
, only 95%, or 950,000 shares are expected to be sold, so the gross proceeds will
be $15 x 950,000 = $14,250,000. After the dealer’s fees, net proceeds will be $14,250,000 –
950,000 = $13,300,000.
Plan II appears to be better as you will receive more money and have sold fewer shares doing so.
However, this option entails more risk for you and the company:
if the IPO doesn’t go very well,
you may raise far less money (and you will still pay the fixed fee).