Ottawa Leaf Limited is considering an investment in new manufacturing equipment.

Question

Ottawa Leaf Limited is considering an investment in new manufacturing equipment. The equipment costs $220,000 and will provide annual aftertax inflows of $50,000 at the end of each of the next seven years. The firm's market value debt/equity ratio is 25%, its cost of equity is 14%, and its pretax cost of debt is 7%. The flotation costs of debt and equity are 3% and 9%, respectively. The firm's combined marginal federal and provincial tax rate is 40%. Assume the project is of approximately the same risk as the firm's existing operations. a) What is OLL's weighted average cost of capital? b) Ignoring flotation costs, what is the NPV of the proposed project? c) What is the weighted average flotation cost for OLL? d) What is the dollar flotation cost for the proposed financing? e) After considering flotation costs, what is the NPV of the proposed project?

Explanation / Answer

a)Weighted average cost of capital

14(0.25)+7(1-0.4)(0.75)= 3.5+3.15= 6.65% without floatation costs.

b) NPV of the proposal
After tax Cash inflows    $50000
Discounted annuity factor @ 6.65% for 7 years is 5.456
Total cash inflows is $272800
Cash outflows is       $220000
Net present value        $52800

c)Weighted average floatation cost

3%(1-0.4)(0.25)+9%(1-0.4)(0.75)=0.45+4.05=4.5%

d) Dollar floatation cost of the financing proposal

Not sure

e)NPV of the project after considering floatation costs
After tax cash flows $50000
Cash flows after considering floatation costs $50000(1-.045)= $47750
Discounted annuity factor @ 6.65% for 7 years is 5.456

Discounted cash flows $260524

Cash outflows                  $220000

NPV                                      $40524

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