Southern Alliance Company needs to raise $21 million to start a new project and

Question

Southern Alliance Company needs to raise $21 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 70 percent common stock, 10 percent preferred stock, and 20 percent debt. Flotation costs for issuing new common stock are 12 percent, for new preferred stock, 7 percent, and for new debt, 2 percent. The true initial cost figure Southern should use when evaluating its project is $ ?

Explanation / Answer

Alliance Company needs to raise 21 million lei to start a new project and will raise the money by selling new bonds. The company has a target capital structure of 60 percent common stock, 20 percent preferred stock, and 20 percent debt. Flotation costs for issuing new common stock are 11 percent, for new preferred stock, 7 percent, and for new debt, 4 percent. What is the true initial cost figure Southern should use when evaluating its project?

We first need to find the weighted average floatation cost.

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      fT = .60(.11) + .20(.07) + .20(.04) = .088 or 8.8%

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      And the total cost of the equipment including floatation costs is:

      Amount raised(1 %u2013 .08800) = 25M   

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      Amount raised = 21M/(1 %u2013 .0880) = 23.0263157895

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