Question

Your company is evaluating a new factory that will cost $23 million to build. Your target debt-equity ratio is 1.7. The flotation cost for new equity is 9% and the flotation cost for new debt is 5%. The company is planning to use retained earnings for 80% of the equity financing.
What are the weighted average flotation costs as a fraction of the amount invested?
What are the flotation costs (in $ million)?

Answer 1

Debt equity ratio = 1.7
It means that when Equity is 1.7 ,debt will be 1.
The total cost to build the factory will be $23 million.
The break up of debt and equity will be as under,
Debt = $23 million * 1.7/2.7 = $14.48 million
Hence Equity = $23 million - $14.48 million = 8.52 million
Outside Equity = Total Equity * (1-80%) = $8.52 million * 20% = $1.70 million
Calculation of weighted average flotation costs
Source of financing	Amount (in miilions)	Weight	Flotation cost	Multiplication
A	B	C	D	C*D
Outside Equity	1.7	0.11	9%	0.0095
Debt	14.48	0.89	5%	0.0447
Weighted average flotation costs				0.0542
Weighted average flotation costs		5.42%
The flotation cost = $16.18 million * 5.42% = $0.88 million