Question

Suppose your company needs $24 million to build a new assembly line. Your target debt-equity ratio is .75. The flotation cost for new equity is 7 percent, but the flotation cost for debt is only 3 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.
Required:
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. 5.29%

B. $25,340,513

Explanation:

a. Calculation to determine the company’s weighted average flotation cost

Average flotation cost = .03(.75/1.75) + .07(1/1.75)

Average flotation cost = .0529*100

Average flotation cost =5.29%

Therefore the company’s weighted average flotation cost will be 5.29%

b. Calculation to determine the true cost of building the new assembly line after taking flotation costs into account

Amount raised=(1 - .0529) = $24,000,000 Amount raised = $24,000,000/(1 - .0529)

Amount raised=$24,000,000/0.9471

Amount raised= $25,340,513

Therefore the true cost of building the new assembly line after taking flotation costs into account will be $25,340,513