Question

3，A company is considering a project which has an initial startup cost of $723,470. The firm maintains a debt-to-equity ratio of 0.82. The flotation cost of debt is 6.02% and the flotation cost of external equity is 10.22%. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs?

Answer 1

Sol:

Startup cost = $723,470

Debt-to-Equity ratio = 0.82

Flotation cost of debt = 6.02%

To determine initial cost of the project including the flotation costs:

Lets assume equity = 1

Debt = 1 x 0.82 = 0.82

Debt weight = 0.82 / (1 + 0.82) = 0.4505

Equity weight = 1 - 0.4505 = 0.5495

Weighted average Flotation cost = (Flotation cost for debt x Debt weight) + (Flotation cost for equity x Equity weight)

Weighted average Flotation cost = (6.02% x 0.4505) + (0 x 0.5495)

Weighted average Flotation cost = (0.0602 x 0.4505) + (0 x 0.5495)

Weighted average Flotation cost = 0.02712 + 0 = 0.02712

There will be no flotation cost for equity, since the firm has sufficient internally generated fund to cover the equity cost of this project.

Initial cost = Startup cost / (1 - Weighted average Flotation cost)

Initial cost = $723,470 / (1 - 0.02712) = $743.637.45

Therefore initial cost of the project including the flotation costs will be $743.637.45