1. Fuzzy Button Clothing Company is considering a one-year project that requires

Question

1. Fuzzy Button Clothing Company is considering a one-year project that requires an initial investment of $600,000; however, in raising this capital, Fuzzy Button will incur an additional flotation cost of 5%. At the end of the year, the project is expected to produce a cash inflow of $900,000. The rate of return that Fuzzy Button expects to earn on the project after its flotation costs are taken into account is _________.

2. Fuzzy Button has a current stock price of $22.35 and is expected to pay a dividend of $2.45 at the end of next year. The company’s growth rate is expected to remain constant at 4%. If the issue's flotation costs are expected to equal 5% of the funds raised, the flotation-cost-adjusted cost of the firm's new common stock is ________.

3. Fuzzy Button’s addition to earnings for this year is expected to be $857,000. Its target capital structure consists of 50% debt, 5% preferred stock, and 45% common stock. Fuzzy Button Clothing Company’s retained earnings breakpoint is _____.

4.A firm will never have to take flotation costs into account when calculating the cost of raising capital from:

a) New Common Stock

b) Retained Earnings

Explanation / Answer

part -1

Cost of New investment is 600000*1.05 = 630,000 with floatation cost

Cash flow after a year 900,000.

Hence return is (900000-630000)/630000 = 0.4286 = 42.86%

Part-2

Cost of the firm = D1/P0 + g

where D1 is the dividend next year = 2.45

P0 = the price this year = 22.35

g=growth rate = 4% =0.04

Hence Cost of Capital = 2.45/22.35 + 0.04 = 0.1496 = 14.96%

Taking into consideration floation costs of 5% Cost of stock = 14.96% + 5% = 19.96%

Part -3

Total Earnings is 857,000 and the cost of equity is 14.96% without floatation costs

Hence Break even retained earnings is 857,000/0.1496 = 5,728,609.62

part-4

A firm will never have to into consideration floatatiion costs with respect to RETAINED EARNINGS.

Since it is the earnings of the company, it can be fully distributed to the shareholders with any floatation costs

Part-4

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