Question

Suppose your company needs $18 million to build a new assembly line. Your target debt-equity ratio is .8. The flotation cost for new equity is 11 percent, but the flotation cost for debt is only 8 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? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)b. What is the true cost of building the new assembly line after taking flotation costs into account? (Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to the nearest whole dollar amount, e.g., 1,234,5667.)

Answer 1

Solution and Explanation:

Calculation of weighted average floatation cost is as follows:

$Floatation cost =\left(\frac{\text { Debt }}{\text { Debt }+\text { Equity }} * \text { cost of the debt }\right)+\left(\frac{\text { Debt }}{\text { Debt }+\text { Equity }} * cost of the equity (ke)) \right.$

$=\left(\frac{.8}{1+0.8} * 8 \%\right)+\left(\frac{8}{1+0.8} * 11 \%\right)$

By calculating the above equation, we get = (0.035556) plus (0.048889)

= 0.08444 = 8.44%  (rounded to 2 decimal places)

The amount of money raised is calculated as follows:

$Amount raised *(1 \text { -Floatation cost) }= Amount required$

$\text { Amount raised } *(1-8.44444 \%)=18000000$

Amount required = 18000000 divided by 0.91556

= 19660098.7

= 19660099 (rounded off)