Question

Suppose your company needs $24 million to build a new assembly line. Your target debt?equity ratio is .60. The flotation cost for new equity is 7 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 do you think about the rationale behind borrowing the entire amount?

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

What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

Answer 1

Part A:

He should not just look at debt cost but also need to look at wighted average floatation cost.

Part B:

The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so:

D/E = 0.60

D = 0.6 * E

Floatation cost of Debt = 3%

Floatation cost of Equity = 7%

Weighted Average Floatation Cost = 3% * 0.6/ 1.6 + 8% * 1/1.6

Weighted Average Floatation Cost = 6.125%

Part C

The total cost of the equipment including flotation costs is:

True Cost * (1 - 6.125%) = 24,000,000

Amount raised = 24,000,000/(1 - 0.06125)

Amount raised = $25,565,912.12

In case the entire amount is raised completely from debt, the flotation costs, and implies true investment cost, should be valued as if the firm’s target capital structure is used.