Question

Suppose your company needs $17 million to build a new assembly line. Your target debt−equity ratio is .75. The flotation cost for new equity is 10 percent, but the flotation cost for debt is only 7 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.)

Flotation cost

%

b.	What is the true cost of building the new assembly line after taking flotation costs into account? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Amount raised

$

Answer 1

Working :

Let equity be 1 .Debt equity ratio = Debt/equity

                                     .75 = Debt /1

                                   Debt = 1*.75 = .75

Total debt +equity = .75+1 =1.75

Weight of Debt =debt /total debt+equity

                        = .75/1.75 = .42857

weight of equity = equity /total debt +equity

                             = 1/1.75 = .57143

a)Weighted average flotation cost=[F debt*weight of debt]+ [F equity * weight of equity]

                                               =[7* .42857 ]+[10*.57143]

                                               = 2.99999+ 5.7143

                                              = 8.71429     [rounded to 8.71%]

b)True cost of building= Amount needed /(1-weighted average flotation cost)

                    = 17,000,000 /(1-.0871429)

                    = 17,000,000 / .9128571

                    = $ 18,622,849