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Manning Co. is considering a one-year project that requires an initial investment of $500,000;...

Question:

Manning Co. is considering a one-year project that requires an initial investment of $500,000; however, in raising this capital, Manning will incur an additional flotation cost of 2.0%. At the end of the year, the project is expected to produce a cash inflow of $550,000.

Determine the rate of return that Manning expects to earn on the project after flotation costs are taken into account.

Flotation Costs:

Flotation costs are transactions costs associated with issuing securities in the capital market. One important component of flotation costs are underwriting fees charged by investment banks.

Answer and Explanation:

We first compute the total cost, including the flotation costs of 2%. Given initial investment of 500,000, the total cost is:

  • 500,000 + 500,000 * 2% = 510,000.

The cash inflow from the project is 550,000 in one year, so the rate of return is

  • rate of return = (550,000 -510,000) / 510,000
  • rate of return = 7.84%

Learn more about this topic:

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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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