Calculating Flotation Costs Suppose your company needs $6 million to build a new

Question

Calculating Flotation Costs Suppose your company needs $6 million to build
a new assembly line. Your target debt-equity ratio is 1.0. The flotation cost for
new equity is 15 percent, but the flotation cost for debt is only 4 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 do you think about the rationale behind borrowing the entire amount?
b. What is your company’s weighted average flotation cost?
c. What is the true cost of building the new assembly line after taking flotation
costs into account? Does it matter in this case that the entire amount is being
raised from debt?

Explanation / Answer

b. The weighted average floatation cost is the weighted average of the floatation costs for debt and equity, so:

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