The Rockettech Corp. 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 1.5%.

Rockettechs financial manager, estimates that the required return on the companys equity is 14%, but 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 8.5%. She therefore recommends that Rockettech should go ahead with the project and finance it with an issue of long-term debt.

Is the financial manager right? How would you evaluate the project, considering that the project has the same business risk as the firms other assets?