Question

Trower Corp. has a debt–equity ratio of .85. The company is considering a new plant that will cost $104 million to build. When the company issues new equity, it incurs a flotation cost of 7.4 percent. The flotation cost on new debt is 2.9 percent. What is the initial cost of the plant if the company raises all equity externally? (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.) Initial cash flow $ What is the initial cost of the plant if the company typically uses 65 percent retained earnings? (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.) Initial cash flow $ What is the initial cost of the plant if the company typically uses 100 percent retained earnings? (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.) Initial cash flow $

Answer 1

Debt - Equity Ratio = Debt / Equity = 0.85 / 1

If debt is 0.85, and Equity is 1, then total capital would be 1.85

Weight of debt = 0.85 / 1.85 , Weight of Equity = 1 / 1.85

The company is going to maintain these weights when raising new capital, so that it can keep the Debt - Equity ratio at 0.85.

Total Capital to be raised = $104 million or $104,000,000

Total Capital to be raised by Equity/ Retained Earnings = $104,000,000 x 1 / 1.85 = 56,216,216.2162

Total Capital to be raised by Debt = $104,000,000 x 0.85 / 1.85 = $47,783,783.7837

Keep in mind that these amounts are to be raised after paying flotation cost.

If all the initial cost is raised externally

Flotation cost on raising equity = Amount to be raised by Equity x Flotation cost = $56,216,216.2162 x 7.4% = $4,160,000

Flotation cost on raising debt = $47,783,783.7837 x 2.9% = $1,385,729.72972

Total Initial Cost = Amount to be raised + Flotation costs = $104,000,000 + $4,160,000 + $1,385,729.72972 = $109,545,729.728 or $109,545,730

If company uses 65% retained earnings

This statement is a bit consfusing but this 65% is supposed to be of the Total Equity capital to be raised rather than total capital. Also note that their will be no flotation cost on retained earnings. Debt portion remains unchanged.

Amount to be raised by external equity = $56,216,216.2162 x (1 - retained earnings) = $56,216,216.2162 x (1 - 0.65) = $19,675,675.6757

Flotation cost on equity = $19,675,675.6757 x 7.4% = $1,456,000

Initial cost of plant = $104,000,000 + $1,456,000 + $1,385,729.72972 = $106,841,729.729 or $106,841,730

If company uses 100% retained earnings

In this case their will be zero flotation costs on equity. Only flotation cost on debt will be incurred.

Initial cost of plant = $104,000,000 + $1,385,729.72972 = $105,385,729.729 or $105,385,730