Question

Lucas Corp. has a debt-equity ratio of .8. The company is considering a new plant that will cost $115 million to build. When the company issues new equity, it incurs a flotation cost of 8.5 percent. The flotation cost on new debt is 4 percent.
A. What is the initial cost of the plant if the company raises all equity externally?
B. What is the initial cost of the plant if the company typically uses 55 percent retained earnings?
C. What is the initial cost of the plant if the company typically uses 100 percent retained earnings?

Answer 1

Answer:

$122,475,000; $119,489,600; $117,047,000

Explanation:

Given the following :

Cost of new plant = $115m

Debt to equity ratio =. 0.8

After issuing new equity:

Floatation cost incurred (equity) = 8.5%

Floatation on new debt = 4%

Calculating weighted return of debt and equity:

Debt: = [0.8/(1 + 0.8)] × 4% = 0.0178

Equity : [1 / (1+ 0.8)] * 8.5% = 0.0472

A) all equity raised externally:

Weighted average Floatation cost:

0.0178 + 0.0472 = 0.065

Initial cash flow will the be :

(1 + 0.065) * cost of new plant

1.065 * $115,000,000 = $122,475,000

B.) company uses 55% Retained earning:

Weighted return on equity will the be :

0.0472 * (1 - 55%) = 0.02124

Weighed Floatation cost = 0.02124 + 0.0178 = 0.03904

(1+0.03904) * $115,000,000 = $119,489,600

C.) Company uses 100% Retained earnings :

Equity return will be 0%

(1 + 0.0178) * 115000000

= $117,047,000