The Ronald Co Ltd (RCL) is contemplating a $40 million national duplication of its replica division. It has forecast after-tax cash flows for the project of $10 million per year in perpetuity. The average yield to maturity of RCL’s is 8 per cent, and its cost of equity capital is 15 per cent. The tax rate is 30 per cent. Harry Lehman, the company’s chief financial officer, has come up with two financial options:
- A $20 million issue of 10-year debt at 8 per cent interest. The issue costs would be 1 per cent of the amount raised.
- A $20 million issue of ordinary shares. The issue costs would be 12 per cent of the amount raised.
The target debt/equity ratio of RCL is 1. The expansion project will have the same risk as the existing business.
- What is the NPV of the new project at the target debt/equity ratio?
- Lehman has advised the company to go ahead with the new project and to utilise the debt option because debt is cheaper, and the issue cost will be less than shares. Is Mr. Lehman correct? Explain.
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