22. APV and issue costs (S18-4) The Bunsen Chemical Company is currently at its target debt ratio of 40%. It is contemplating a $1 million expansion of its existing business. This expansion is expected to produce a cash inflow of $130,000 a year in perpetuity.

The company is uncertain whether to undertake this expansion and how to finance it. The two options are a $1 million issue of common stock or a $1 million issue of 20-year debt. The flotation costs of a stock issue would be around 5% of the amount raised, and the flotation costs of a debt issue would be around 1½%.

Bunsen’s financial manager, Polly Ethylene, estimates that the required return on the company’s equity is 14%, but she argues that the flotation costs increase the cost of new equity to 19%. On this basis, the project does not appear viable. On the other hand, she points out that the company can raise new debt on a 7% yield, which would make the cost of new debt 8½%.

She therefore recommends that Bunsen should go ahead with the project and finance it with an issue of long-term debt.

Is Ms. Ethylene right? How would you evaluate the project?

Chapter 18 Financing and Valuation 549