Question

Suppose your company needs $13 million to build a new assembly line. Your target debt-equity ratio is .55. The flotation cost for new equity is 6 percent, but the flotation cost for debt is only 3 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?
B. What is the true cost of building the new assembly line after taking flotation costs into account?

Answer 1

A. The company’s weighted average flotation cost, assuming all equity is raised externally is:

= 4.35%.

B. The true cost of building the new assembly line after taking flotation costs into account is:

= $13.39 million.

Step-by-step explanation:

a) Data and Calculations:

Amount needed to build a new assembly line = $13 million

Target debt-equity ratio = 0.55

Therefore, the weight of equity = 1 - 0.55 = 0.45

Flotation cost for new equity = 6%

Flotation cost for debt = 3%

Weighted average flotation cost = (Equity flotation cost * weight) + (Debt flotation cost * weight)

= 6% * 0.45 = 2.7%

+ 3% * 0.55 = 1.65%

Weighted Average = 4.35%

True cost of building the new assembly line:

Amount needed to build a new assembly line = $13 million

Plus Debt flotation cost (3% of $13 million) 0.39 million

Total cost of building the assembly line, including flotation cost = $13.39 million

b) Note that the interest payments are not included in the above cost.