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, but the flotation cost for debt is only 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.

What is your company’s weighted average flotation cost, assuming all equity is raised externally?

Answer 1

9.14%

Step-by-step explanation:

The cost of debt is the rate of return required by the bondholders or fund lenders. The cost of debt is a part of company's capital structure.

The cost equity is the rate of return required by the equity investors. The equity is considered more risky than debt as from investor perspective therefore investors require high return for equity than debt.

The weighted average flotation cost for the company is calculated using the target debt equity ratio,

Cost of debt * debt - equity ratio + cost of equity * debt equity ratio

0.07 * 0.4 / 1.4 + 10 * 1 / 1.4

The weighted average flotation cost = 0.02 + 0.07

The flotation cost = 9.14%