Question

To build the new factory, your company needs $56 million. The target debt-equity ratio is 0.56. The flotation cost for new equity is 7% and the flotation cost debt is 3%. Your boss has decided to fund the project by borrowing money because the floatation cost is lower and the needed funds are relatively small.
a. What is your company's weighted average flotation cost, assuming all equity is raised externally?
b. What is the true cost of building the new assembly line after taking flotation cost into account? Does it matter in this case that the entire amount is being raised from debt?
Shows all the step and formula. Don't round off until you get the answer.

Answer 1

A. Weighted average flotation cost = flotation cost of equity*weight of equity + flotation cost of debt*weight of debt

= 3%*0.56/1.56 + 7%*1/1.56

= 5.56%

B. True cost = funds required/(1-weighted average flotation cost)

= 56,000,000/(1-5.56%)

=$59,296,908.09

Yes, if the entire amount is raised from debt, amount required = 56,000,000/(1-3%)

=$57,731,958.76