Question

show formula and detail step,please Thank you!

3. Suppose your company needs $20 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. a. What do you think about the rationale behind borrowing the entire amount? b. What is your company’s weighted average flotation cost, assuming all equity is raised externally? c. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

Answer 1

A.In the above situation, the expected return by equity shareholder or floating cost for new equity is 7% while if the amount is borrowed the floating cost is only 3% . thus, if the company borrows the entire amount it saves a total of 4% (7%-3%) of its total cost.

Thus, if cost is taken into account it was best to borrow the entire amount externally rather than a mix of both.

B. If the entire equity is raised externally than the weighted average cost will be $0.6 million i.e. $20*3%

C. True cost of building:

Total cost = principal amount + cost incurred (floating cost)

= $20 million + $0.6 million (%20*3%)

= $20.6 million

D. Yes, it totally matters if the company raise the amount from debt because it affects tge liquidity of the company . more debt means more risk as their is a compulsory obligation to pay interest on loan. And if the company fails to pay interest it may go in the situation of debt trap.

The best way is to have a mix of both debt and equity, they should be present in equal amount in a company.