Calculating Flotation Costs Suppose your company needs $20 million to build a ne

Question

Calculating Flotation Costs Suppose your company needs $20 million to build
a new assembly line. Your target debt-equity ratio is .75. The flotation cost for
new equity is 8 percent, but the flotation cost for debt is only 5 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 assuming all equity is raised externally?
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

a.He should look at the weighted average flotation cost, not just the debt cost.
b.The weighted average floatation cost is the weighted average of the floatation costs for debt and equity, so:
fT = .05(.75/1.75) + .08(0.08/1.75) = 0.004
c.The total cost of the equipment including floatation costs is:
Amount raised(1 – .004) = 20M
Amount raised = 20M/(1 – .004) = 20,080,321.29
Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used.

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