Question

Thinking Hat would like to start a new project which will require $25 million in the initial cost. The company is planning to raise this amount of money by selling new corporate bonds. It will generate no internal equity for the foreseeable future. Thinking Hat has a target capital structure of 55 percent common stock, 10 percent preferred stock, and 35 percent debt. Flotation costs for issuing new common stock are 10 percent, for new preferred stock, 7 percent, and for new debt, 3 percent. What is the true required initial investment that the company should use in its valuation of the project

Answer 1

True required initial investment = $26,954,178

Explanation :

As per the data given in the question, we need to do following calculations

Weighted average flotation cost = ( % flotation cost of debt × weight of debt) + (% flotation cost of preferred equity × weight of preferred equity) + (% flotation cost of common equity × weight of common equity)

= (3% × 35%) + (7% × 10%) + (10% × 55%)

= 0.0725

=7.25%

It means out of total capital which is raised 7.25%, would be the flotation cost.

Let total capital raised be X

So X × (1 - 7.25%) = $25 million

X = $25 million ÷ (1- 7.25%)

X = $26,954,178