Suppose your company needs 13 million to build a new assembl

Suppose your company needs $13 million to build a new assembly line. Your target debt?equity ratio is .55. The flotation cost for new equity is 6 percent, but the flotation cost for debt is only 3 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.

What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

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

Solution

(a) Target Financing Mix is 0.55 of debt and 1 of Equity. Therefore, out of total financing 0.355 is debt and 0.645 is equity.

Equity Flotation Cost = 6 % and Debt Flotation Cost = 3 %

Weighted Average Flotation Cost = 0.355 x 3 + 0.645 x 6 = 4.935 or 4.93 % approximately.

(b) Total Financing = $ 13 million

Debt = 0.355 x 13 = $ 4.615 million and Equity = 0.645 x 13 = $ 8.385 million

Debt Flotation Cost = 3 % of Debt Raised = 0.03 x 4.615 = $ 0.13845 million and Equity Flotation Cost = 6 % of Equity Raised = 8.385 x 0.06 = $ 0.5031 million

Total Cost of Financing = 13 + 0.13845 + 0.5031 = $ 13.64155 million or $ 14 million approximately.