THIS IS NOT THE ANSWER: 1. floatation cost of equity = 9% or 0.09 Amount require
ID: 2727520 • Letter: T
Question
THIS IS NOT THE 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.
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
The assumptions taken as per the problem
The initial cost of investment is $120,000,000
The debt equity ratio is .85
The floatation cost of equity is 9%
The floatation cost of debt is 4.5%
What is the initial cost of the plant if the company raises all equity externally
If equity is used for the project. the amount raised will be calculated
Cost of project = (1- floatation cost of equity ) x amount raised
Amount raised = cost of project / 1-floatation cost
Amount raised = 120,000,000 / (1-.09)
Amount raised = 120,000,000 / 0.91 = $131,868,132
What is the initial cost of the plant if the company typically uses 100 percent retained earnings?
The amount raised will be cost of project in case of retained earnings is $120,000,000
What is the initial cost of the plant if the company typically uses 65 percent retained earnings?
The amount raised through retained earnings = 120,000,000 x 65% = $78,000,000
The balance to be raised by equity and debt is = $120,000,000 - $78,000,000 = $42,000,000
We will calculate the weighted average floatation cost
Let us first calculate the weight of equity if debt equity ratio is .85
Weight of debt = .85/1.85 = 0.4594 or 45.95%
Weight of equity = 1-0.4594 = 0.5406 or 54.06%
To calculate the weighted average floatation cost
= weight of debt x floatation cost + weight of equity x floatation cost
= 45.95% x 0.045 +54.06% x 0.09
= 6.93%
Cost of project = (1- weighted average floatation cost ) x amount raised
Amount raised = cost of project / 1-floatation cost
Amount raised = 42,000,000 / (1-.0693)
Amount raised = 42,000,000 / 0.9307 = $ 45127324
The total amount raised = retained earnings amount + amount raised by equity and debt
= $78,000,000 + $45,127,324
= $123,127,324
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