Question

Southern Alliance Company needs to raise $70 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 70 percent common stock, 15 percent preferred stock, and 15 percent debt. Flotation costs for issuing new common stock are 10 percent, for new preferred stock, 7 percent, and for new debt, 2 percent.

What is the true initial cost figure the company should use when evaluating its project? (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 dollar amount, e.g., 32.)

  

Initial cost

$

Answer 1

Eventhough the entire project cost of $ 70 million is initially raised through selling bonds (akin to raising debt), the project will converge at the firm's target capital structure with passage of time. Further, as the firm is not expected to generate any internal equity, when the move towards the target capital structure happens, the other components of the capital structure (preferred and common stock) will have to raised, thereby incurring flotation costs. Flotation costs will also be incurred when the firm raises debt (in the form of bonds). For analytical purposes, the true project cost would include the investments in each of the three capital components (bond, preferred stock and common stock) plus any flotation costs associated with each of these capital components.

Weight of Bonds in Capital Structure = 15 %, Weight of Preferred Stock in Capital Structure = 15 % and Weight of Common Stock in Capital Structure = 70 %

Total Capital Raised = $ 70 million

Amount of Debt Raised = (70 x 0.15) = $ 10.5 million

Flotation Cost for New Debt = 2 % of Amount Raised = 0.02 x 10.5 = $ 0.21 million

Total Outlay of Raising Debt = D = 10.5 + 0.21 = $ 10.71 million

Amount of Preferred Stock Raised = (70 x 0.15) = $ 10.5

Flotation Cost for New Preferred Stock = 7 % of Amount Raised = 0.07 x 10.5 = $ 0.735 million

Total Outlay of Raising Preferred Stock = P = 0.735 + 10.5 = $ 11.235 million

Amount of Common Stock Raised = (70 x 0.7) = $ 49 million

Flotation Cost for New Common Stock = 10 % of Amount Raised = 0.1 x 49 = $ 4.9 milliom

Total Outlay of Raising Common Stock = E = 49 + 4.9 = $ 53.9 million

Total True Project Cost = D + P + E = 10.71 + 11.235 + 53.9 = $ 75.845 million or $ 75845000