Only question (b) required: need some explanations

Question 3: The Ronald Co Ltd (RCL) is contemplating a $40 million national duplication of its replica division. It has W3 after-tax cash flows for the project of $10 million per year in perpetuity. 5% average yield to maturity is 8 per cent and its cost of equity capital is 15 per cent. The tax rate is 30 per cent. Harry Lehman, the company's chief nancial officer, has come up with two nancial options: 1) A $20 million issue of 10-year debt at 8 per cent interest. The issue cost would be 1 per cent of the amount raised. 2) A $20 million issue of ordinary shares. The issue cost would be 12 per cent of the amount raised. The target debt/equity ratio of RCL is 1. The expansion project will have the same risk as the existing business. (a) What is the NP'yr of the new project at the target debt/equity ratio? [5 marks] From the scenario, we can get the information in the following: Re: 0.15, Rd: 0.08,t = 30%,,fg= 012,123: 0.01 Cash ow = $10 millions, V = $40 millions, D = $20 millions, E = $20 millions Lg = (EM *gDm $.02: (20f40) * 0.12 + (20f40) * 0.01 = 0.065 True cost ofproject = Project cost! (Lg) = 40mf(1-0.065) = $42.38 millions 2. WACC= (EN) * Re+ (DIV) * Rd * (10 = (20/40) * 0.15 + (20140) * 0.08 * (1 0.3) = 0.103 3. NPV = -42.TSm + 10mf(0. 103) = $54.31 millions, which is larger than 0. (b) Mr. Lehman has advised the company to go ahead with the new project and to 533.11% the debt option because debt is cheaper, and the issue cost will be less than shares. Is Mr. Lehman correct? Explain. [5 marks] From the above, NPV of the new project is indeed larger than 0, thus Mr. Lehman can accept it