Suppose your company needs $15 million to build a new assembly line. Your target

Question

Suppose your company needs $15 million to build a new assembly line. Your target debt-equity ratio is 0.94. The flotation cost for new equity is 10 percent, but the flotation cost for debt is only 4 percent.

Requirement 2: What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16)) Weighted average flotation cost % ___________.

Requirement 3: What is the true cost of building the new assembly line after taking flotation costs into account? (Do not include the dollar sign ($). Round your answer to the nearest whole dollar amount. (e.g.,1,234,567)) True cost $_________.

Explanation / Answer

Requirement 2- The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so: FT= 0.04(0.94/1.94) + 0.10(1/1.94) =0.07092, or 7.09%

Requirement 3-The total cost of the equipment including flotation costs is:

Amount raised(1 – 0.07092) = $15,000,000

Amount raised = $15,000,000/(1 – 0.07092) = $16,145,004

Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used.

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