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-TECONANS ltd is contemplating a P20 million expansion project in its power systems decisions. It has forecast after tax cash flows for the project as P8 million per year in perpetuity. The cost of debt capital for the TECONANS is 10%, and its cost of equity capital is 20%. The tax rate is 34%. Mrs Trump, the Chief Finance Officer for the company, has come up with two financing options:
-A P20 million issue of 10-year debt at 10% interest. The issue costs could be 1% of the amount raised.
-A P20 million issue of common stock. The issue costs of the common stock would be 15% of the amount raised. The target debt/equity ratio of TECONANS is 2. The expansion project will have about the same risk as the existing business.
Mr. T.E has advised the company to go ahead with the new project and to use debt because debt is cheaper and the issue cost will be less with debt.
REQUIRED:
i. Advise the company whether Mrs. Trump is correct.
ii. Compute the NPV of the new project and comment on your answer.
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