When a firm has flotation costs equal to 7 percent of the funding need,project analysts should:
A)increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.07.
B)increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - 0.07).
C)add 7 percent to the firm's WACC to get the discount rate for the project.
D)increase the initial project cost by multiplying that cost by 1.07.
E)increase the initial project cost by dividing that cost by (1 - 0.07).

Question

Quizplus · Accepted Answer

To account for flotation costs equal to 7 percent of the funding need, the correct approach is to adjust the initial project cost. This is done by dividing the initial cost by (1 - 0.07) to ensure that the total amount raised, after accounting for the flotation costs, is sufficient to cover the project's needs. This method directly adjusts the project's initial cost to reflect the additional expenses incurred from raising new capital, rather than altering the discount rate or the firm's weighted average cost of capital (WACC).

When a Firm Has Flotation Costs Equal to 7 Percent