The answer to this question is at the end. I do not understand how the average f
ID: 2713069 • Letter: T
Question
The answer to this question is at the end. I do not understand how the average flotation cost is calculated. Specifically, I am stuck on where the numbers came from.
Rodney Ruxin's Legal Services is raising capital to open a new law office in southern California. The project has an initial start up cost of $1,349,107. The firm maintains a debt-equity ratio of 0.50 and has a flotation cost of debt of 6.8 percent and a flotation cost of equity of 11.4 percent. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs (enter your response as positive number, i.e. initial investment of $1 million as 1000000)?
Since the firm has sufficient internally generated equity, they do not have to issue stock and will not incur the floatation cost for equity.
Average flotation cost = (1/1.5) (0.0) + (0.5/1.5) (0.068) = 0.0227
Initial cost = $1,349,107/(1 - 0.0227) = $1380443.057
Explanation / Answer
Debt equity ratio = Debt /equity
= .50 /1
Total debt and equity = Debt +equity
= .50 +1
= 1.50
Weight of debt = .50 /1.50 = .3333
Weight of equity = 1 / 1.50 = .6667
Floatation cost = (Floatation cost of debt *Wd ) +(Floatation cost of equity *We)
= (6.8 *.3333 ) +(0 *.6667)
= 2.266 + 0
= 2.266 % (approx 2.27 %)
**Since company has sufficient funds(Retained earnings) to cover equity cost of project .so no need to raise funds from outside business so no floatation cost for raising equity .
Initial cost (Including Floatation cost) = Initial cost excluding Floatation cost / (1 -Average floatation cost)
= 1,349,107 / (1 -.0227)
= 1,349,107 / .9773
= $ 1,380,43.06
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