Right way for float costs (New LOS from 07)

D

ditchdigger2CFA

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The most accurate way to account for flotation costs when issuing new equity to finance a project is to:

A) adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.

B) increase the cost of equity capital by dividing it by (1 � flotation cost).

C) increase the cost of equity capital by multiplying it by (1 + flotation cost).

D) adjust cash flows in the computation of the project NPV by incorporating the flotation cost into the discount rate used to compute the project NPV.
 
Def A. But you just add the cost to the cost of the entire project at CF = 0

You don't adjust all cash flows
 
I think we need to increase Ke so B or C. C does it for sure.
 
On first look at this one I was thinking either A or D and it would have been a 50/50 guess.

I went back to the CFAI books and Vol 4 pp 10 under the principles of capital budgeting it says:

5. Financing costs are ignored ... capturing the costs of capital in the discount rate.

therefore I think that D is the closest to the mark
 
OV, that is incorrect.

The recommonended approach is to make the adjustment to the cash flows in the valuaton comp (Page 69 Vol. 4)

The cfa text says to adjust NPV and schweser says to just the intial outflow. I guess this is the same?
 
from memory...
it's either added to CF0, which is the preferred method
or it's incorporated in the discount rate.

So I would say D.

Ditch, what is the right answer?
 
Your answer: D was incorrect. The correct answer was A) adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.

Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project.
 
Wow that goes directly against what is said in the text. I agree the answer makes sense but it is leaving me a little doubtful to say the least.

Where did this question come from??
 
thanks beingthatguy!. I recall now (after u've pointed it out) ...
 
hey aussie_jaco.....check out that page.

The recommonended approach is to make the adjustment to the cash flows in the valuaton comp (Page 69 Vol. 4)

I think the financing you are thinking of is interest from a loan
 
Thanks for the heads up Being.

Apparently the difference is between Financing costs and Flotation costs, I would have thought that they were the same thing. But I have been shown the error of my ways.

If I pass this thing it will be in part due to the learning from this board.
 
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