When a company raises funds through external debt or equity, it must incur flotation costs. Assume that the municipal government no longer sponsored the project and PPM, Inc. must obtain $5,000,000 with new debt at the market interest rate of 10%.
Flotation costs are 12.5% of gross proceeds.
Since the company must have $5,000,000 in net proceed, it must raise $5,000,000/(1 -0.125) = $5,714,286.
The $714,286 flotation cost is a cash expense today.
The U.S. tax code allows this expense to be amortized over five years, resulting in a ($714,286/5 years) = $142,857 deduction per year. Annual tax shields from amortization of the flotation costs are (.34)($142,857) = $48,571. The net present value of the after?tax flotation cost is:
NPV(flotation cost) = -$714,286 + $48,571 × [1 - (1/1.1)5]/.1 = -$714,286 + $184,124 = -$530,162
In your own words, how would you explain the impact of flotation cost of the proposed initiative to the founder who is not fluent in corporate finance?