Question

Suppose your company needs $10 million to build a new assembly line. Your target debt-equity ratio is .4. The flotation cost for new equity is 10 percent and the flotation cost for debt is 7 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small.

a.	What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the true cost of building the new assembly line after taking flotation costs into account? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole dollar amount, e.g., 1,234,567.)

Answer 1

(a)-Company’s weighted average flotation cost

Company’s weighted average flotation cost is the weighted average cost of the flotation cost for the debt and flotation cost for the new equity

Weighted average flotation cost = [Flotation cot for Debt x Weight of Debt] + [Flotation cost for new equity x Weight of Equity]

= [0.07 x (0.40/1.40)] + [0.10 x (1.00/1.40)]

= [0.07 x 0.2857] + [0.10 x 0.7143]

= 0.02000000 + 0.07142857

= 0.09142857

= 9.14% (Rounded to 2 decimal place)

“Hence, the Company’s weighted average flotation cost would be 9.14%”

(b)-The true cost of building the new assembly line after taking flotation costs into account

Cost of the Equipment including the flotation cost = Amount raised x (1 - weighted average flotation cost)

$100,00,000 = Amount raised x (1 – 0.09142857)

$100,00,000 = Amount raised x 0.90857143

Amount raised = $100,00,000 / 0.90857143

Amount raised = $11,006,289

“Therefore, the true cost of building the new assembly line would be $11,006,289”