Suppose your company needs $16 million to build a new assembly line. Your target

Question

Suppose your company needs $16 million to build a new assembly line. Your target debtequity ratio is .6. The flotation cost for new equity is 12 percent, but the flotation cost for debt is only 9 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? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What is the true cost of building the new assembly line after taking flotation costs into account? (Enter your answer in dollars, not millions of dollars, e.g. 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.)

Suppose your company needs $16 million to build a new assembly line. Your target debtequity ratio is .6. The flotation cost for new equity is 12 percent, but the flotation cost for debt is only 9 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.

Explanation / Answer

a)

Debt equity ratio = Debt:Equity = 0.6:1

Weighted average flotation cost:

= (0.6×9%+1×12%)÷(1+0.6)

= 10.88%

b)

True cost of building:

= $16 million÷(1-10.88%)

= $17,953,321

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