Your company is evaluating a new factory that will cost 23 m

Your company is evaluating a new factory that will cost $23 million to build. Your target debt-equity ratio is 1.7. The flotation cost for new equity is 9% and the flotation cost for new debt is 5%. The company is planning to use retained earnings for 80% of the equity financing.
What are the weighted average flotation costs as a fraction of the amount invested?
What are the flotation costs (in $ million)?

Solution

Debt equity ratio = 1.7 It means that when Equity is 1.7 ,debt will be 1. The total cost to build the factory will be $23 million. The break up of debt and equity will be as under, Debt = $23 million * 1.7/2.7 = $14.48 million Hence Equity = $23 million - $14.48 million = 8.52 million Outside Equity = Total Equity * (1-80%) = $8.52 million * 20% = $1.70 million Calculation of weighted average flotation costs Source of financing Amount (in miilions) Weight Flotation cost Multiplication A B C D C*D Outside Equity 1.7           0.11 9%                    0.0095 Debt 14.48           0.89 5%                    0.0447 Weighted average flotation costs                    0.0542 Weighted average flotation costs 5.42% The flotation cost = $16.18 million * 5.42% = $0.88 million