Question

Thinking Hat would like to start a new project which will require $21 million in the initial cost. The company is planning to raise this amount of money by selling new corporate bonds. It will generate no internal equity for the foreseeable future. Thinking Hat has a target capital structure of 65 percent common stock, 12 percent preferred stock, and 23 percent debt. Flotation costs for issuing new common stock are 10 percent, for new preferred stock, 10 percent, and for new debt, 4 percent. What is the true required initial investment that the company should use in its valuation of the project? (Do not round your intermediate calculations.)

r
ev: 09_20_2012Multiple Choice

• $19,320,000

• $22,061,721

• $23,900,197

• $22,810,200

• $22,980,959

Answer 1

Solution:

The formula for calculating the weighted average floatation cost is =

Weighted average floatation cost = [ FCc * Wc ] + [ FCp * Wp ] + [ FCd * Wd ]

FCc = Floatation Cost of Common stock ; Wc = Weight of Common stock;

FCp = Floatation Cost of Preferred stock ; Wp = Weight of Preferred stock ;         

FCd = Floatation Cost of Debt  ; Wd = Weight of Debt

As per the information available in the question we have

FCc = 10 %    ; Wc = 65 % = 0.65 ;   FCp = 10 %   ; Wp = 12 % = 0.12 ;   

FCd = 4 %   ; Wd = 23 % = 0.23

Applying the above values in the formula we have

= [ 10 % * 0.65 ] + [ 10 % * 0.12 ] + [ 4 % * 0.23 ]

= 6.50 % + 1.20 % + 0.92 %

= 8.62 %

Thus the weighted average floatation cost is = 8.62 %

Calculation of the true required initial investment:

The true required initial investment that the company should use in its valuation of the project is calculated using the formula

= Initial Investment / ( 1 – Weighted average floatation cost )

As per the information available we have

Initial Investment = $ 21,000,000 ;   Weighted average floatation cost = 8.62 % = 0.0862

Applying the above information in the formula we have

= $ 21,000,000 / ( 1 – 0.0862 )

= $ 21,000,000 / 0.9138

= $ 22,980,958.6343

= $ 22,980,959

Thus the true required initial investment that the company should use in its valuation of the project = $ 22,980,959

The solution is Option 4 = $ 22,980,959