Suppose your company needs $20 million to build a new assembly line. Your target

Question

Suppose your company needs $20 million to build a new assembly line. Your target debt-equity ratio is .8. The flotation cost for new equity is 9 percent, but the flotation cost for debt is only 6 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.

a.What is the true cost of building the new assembly line after taking flotation costs into account

What is your company’s weighted average flotation cost, assuming all equity is raised externally?

Suppose your company needs $20 million to build a new assembly line. Your target debt-equity ratio is .8. The flotation cost for new equity is 9 percent, but the flotation cost for debt is only 6 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

1) Calculation of true cost of building :

Given Debt equity ratio = .8 that means debt portion is 80% and equity portion is 20%

Flotation cost for equity is 9%

Flotation cost for debt is 6%

Therefore true cost of building is

$20,000,000×20%×9%+$20,000,000×80%×6% = $1,320,000

2) Calculation of true cost of building when all equity is raised externally:

$20,000,000×6% = $1,200,000

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