Sheaves Corp. has a debtequity ratio of .85. The company is considering a new pl

Question

Sheaves Corp. has a debtequity ratio of .85. The company is considering a new plant that will cost $120 million to build. When the company issues new equity, it incurs a flotation cost of 9 percent. The flotation cost on new debt is 4.5 percent.

What is the initial cost of the plant if the company raises all equity externally? (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.)

What is the initial cost of the plant if the company typically uses 65 percent retained earnings? (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.)

What is the initial cost of the plant if the company typically uses 100 percent retained earnings? (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.)

Sheaves Corp. has a debtequity ratio of .85. The company is considering a new plant that will cost $120 million to build. When the company issues new equity, it incurs a flotation cost of 9 percent. The flotation cost on new debt is 4.5 percent.

Explanation / Answer

1. floatation cost of equity = 9% or 0.09

Amount required = (1-floatation cost)*initial cash flow

$120 million = (1-0.09)*initial cash flow

or initial cash flow = 120 million/(1-0.09) = 120 million/0.91 = $131,868,132

2. Amount of cost covered by retained earnings = $120 million * 65% = $78 million. balance = 120-78 = $42 million.

Now, this amount will be financed by a debt equity ratio of 0.85 i.e equity will be 1 and debt will be 0.85

proportion of debt in total capital requirement = debt/(debt+equity) = 0.85/(0.85+1) = 0.4595. proportion of equity = 1-0.4595 = 0.5405

Thus, amount raised through debt = debt's proportion*balance amount required = 0.4595*$42 million = $19.3 million. Thus, $19.3 million = (1-debt's floatation cost)*initial cash flow

or 19.3 million = (1-0.045)*initial cash flow. Initial cash flow = 19.3/(1-0.045) = $20.21 million

amount raised from equity = balance amount *equity proportion = $42 million*0.5405 = 22.70 million

22.70 million = (1-0.09)*initial cash flow

or initial cash flow = 22.7/0.91 = $24.95 million

Thus initial cash flow = cash flow from retained earnings+cash flow from debt+cash flow from equity = $78 million+$20.21million +$24.95 million = $123,154,619

3. when 100% retained earnings is used there is no floatation costs involved. Thus, initial cash flow = cost = $120,000,000.

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