Question

Suppose your company needs $18 million to build a new assembly line. Your target debt-equity ratio is .7. The flotation cost for new equity is 7 percent, but the flotation cost for debt is only 4 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.a. What is your company’s weighted average flotation cost, assuming all equity is raised externally?b. What is the true cost of building the new assembly line after taking flotation costs into account?

Answer 1

Answer:

a. Weighted average flotation cost

   = FCE(E/V)  + FCD(D/V)

   = 7(100/170) + 4(70/170)

   = 4.12 + 1.65

   = 5.77%

V = E + D

V = 100 + 70 = 170

b. Flotation cost of debt financing

  = 4% x $18 million

  = $0.72 million

True cost of the building after taking flotation cost into account

= $18 million + $0.72

= $18.72

Explanation:

The weighted average flotation cost is the flotation cost of equity multiplied by the proportion of equity in the capital structure plus flotation cost of debt multiplied by proportion of debt in the capital structure. The total market value is 100 + 70 = 170. Since the debt-equity ratio is 0.7. Debt takes 70 while equity takes 100. The proportion of equity in the capital structure is 100/170 while the proportion of debt in the capital structure is 70/170.