Question

Cully Company needs to raise $23 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 55 percent common stock, 10 percent preferred stock, and 35 percent debt. Flotation costs for issuing new common stock are 8 percent, for new preferred stock, 6 percent, and for new debt, 4 percent. What is the true initial cost figure Southern should use when evaluating its project?

• $23,589,744

• $24,472,000

• $24,572,650

• $21,620,000

• $25,555,556

Answer 1

Cully Company needs to raise $23 million to start a new project and will raise the money by selling new bonds.

The company has a target capital structure of 55 percent common stock, 10 percent preferred stock, and 35 percent debt.

Flotation costs for issuing new common stock are 8 percent, for new preferred stock, 6 percent, and for new debt, 4 percent.

What is the true initial cost figure Southern should use when evaluating its project?

A company can has various sources of finance available for itself which includes issue of common stock, issue of preferred stock and issue of bonds. The costs associated with issue of each of the sources of capital usually is different and hence based on the proportion of each security, a weighted average flotation cost is being computed. Weighted average flotation cost is calculated using the each securities floatation cost multiply with its wieght in the capital structure, And add ecah to find weighted average flotation cost.

And use the weighted average flotation cost to find the initial cost figure Southern should use when evaluating its project.

The true initial cost that should be used in evaluating the project is $24572650

Calculation

first calculate  weighted average flotation cos

weighted average flotation cost = ( Flotation cost of equity * weight of equity in the capital structure ) +  ( Flotation cost of preferred stock * weight of preferred stock in the capital structure ) +  ( Flotation cost of debt * weight of debt in the capital structure )

Here,

Flotation cost of equity = 8%

weight of equity in the capital structure = 55%

Flotation cost of preferred stock = 6%

*weight of preferred stock in the capital structure = 10%

Flotation cost of debt = 4%

weight of debt in the capital structure = 35%

weighted average flotation cost = (8 * 55% ) + ( 6 * 10%) + ( 4 * 35% )

weighted average flotation cost = 4.4 + 0.6 + 1.4 = 6.4% = 0.064

true initial cost figure = required fund / ( 1 -  weighted average flotation cost percent)

true initial cost figure = 23000000 / ( 1 - 0.064 )

true initial cost figure =  23000000 / 0.936 = 24572649.57 =   24572650

This is the initial true cost for the evaluation