Question

You are the manager of the upper teir company, a company that has a target debt equity ratio of .45. the company is considering a project with an initial investment $1,000,000. The present value of the future cash flow of the project is 1,050,000. the cost of the floating equityis 9.5% and the floation cost of debt is 6.6%. twenty five percent if equity will come from retained earnings. what should the firm use as their weighted aberage floation cost? if the firm were to invest 1,000,000 in the project how much money does it have to raise (round to the nearest dollar). will you invest in the project if there were no floatation costs abd (b) there were floatation costs?

Answer 1

WEIGHTED AVERAGE FLOTATION COST

The debt-equity ratio is 0.45 or 9/20. This means that all projects must be financed with 9/29 of total investment as Debt and 20/29 of total investment as Equity.

This implies that the Debt investment is 9/29 of $1,000,000 = $310,344.8276 = $310,345,

and Equity investment is 20/29 of $1,000,000 = $689,655.1724 = $689,655.

Out of the Equity investment of $689,655, $172,414 (25% of Equity) is financed by Retained Earnings and the remaining $517,241 is financed by raising fresh equity.

Flotation Costs are incurred only when new securities are issued. Therefore, the flotation cost on using retained earnings is zero.

The weighted average flotation cost is summation of flotation costs of securities * their respective weights in the investment.

For Retained Earnings: ($172,414 / $1,000,000) * 0% = 0%

For Equity: ($517,241 / $1,000,000) * 9.50% = 4.9137895%

For Debt: ($310,345 / $1,000,000) * 6.60% = 2.048277%

Therefore, the Weighted Average Flotation Cost is 6.96% (0% + 4.9137895% + 2.048277% = 6.9620665%).

AMOUNT OF MONEY TO BE RAISED BY THE FIRM

Before accounting for Flotation costs, the firm needs to raise $517,241 by issue of equity and $310,345 by issue of debt to meet its investment and target capital structure.

After accounting for flotation costs, the additional amount to be raised is:

Flotation Cost of Equity = 9.50% of $517,241 = $49,137.895

Flotation Cost of Debt = 6.60% of $310,345 = $20,482.77

The total amount required by the company now is:

$1,000,000 + $49,137.895 + $20,482.77 = $1,069,620.665 = $1,069,621.

To meet the target debt-equity ratio of 0.45, the amount to be raised by:

Equity = $1,069,621 * (20/29) = $737,669.6552 = $737,670

Debt = $1,069,621 * (9/29) = $331,951.3448 = $331,951

Out of the Equity amount, $184,418 is raised through Retained earnings (25% of Equity) and the remaining $553,252 by fresh issue of Equity and fresh Debt of $331,951 is to be issued.

INVESTMENT DECISION

If flotation costs ARE NOT considered, the return on capital employed is:

$1,050,000 / $1,000,000 = 105%.

If flotation costs ARE considered, the return on capital employed is:

$1,050,000 / $1,069,621 = 98.17%.

Therefore, I would invest in the project without flotation costs. Flotation cost is the cost of raising new capital that is incurred at the beginning of the project. Being a cost, it always reduces the returns generated on projects and if given an option, choosing not to pay flotation costs is prudent.