The Pecking Order of Financing Alternatives: Axon Industries needs to raise $10 million for a new investment project

RETAINED EARNINGS:

If Axon spends $10 million out of retained earnings, then it'll forego the dividends and reinvest the earnings worth $10 million to finance the project.

Thus, the cost of reinvesting will be $10 million which would have otherwise been paid to shareholders in the form of dividends.

DEBT:

If Axon issues one-year debt, the total cost to the firm would be the principal amount plus the interest paid on $10 million.

Thus, Total Cost= 10(1.07) = $10.7 million in one year, the present value of which is the total cost discounted at the fair rate at the level of risk that is 6%.

Effective Cost= 10.7/1.06 = $10.094 million.

EQUITY:

If equity is under priced by 5.5%, it essentially implies that if a share of Axon is worth $100, it is being sold at $94.5. then to raise $10 million, Axon will have to issue $10000000/94.5 = 105820.11 shares.

The book value of these shares will be 105820.11*100= $10582011 $10.582 million .

Thus, the cost of financing the project with equity will be $10.58 million.