Question

Calculating Flotation Costs 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. a. What do you think about the rationale behind borrowing the entire amount? b. What is your company’s weighted average flotation cost, assuming all equity is raised externally? c. 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

a) The rationale behind borriwng the amount is to benefit of lower flotation costs. This reduces the cost of funds and increases profitability.

b)Debt/Equity = 0.6/1 which means total value= 0.6+1= 1.6

Weight of equity = 1/1.6

Weight of debt = 0.6/1.06

Weighted flotation cost= 7%*1/1.6+ 3%*0.6/1.6

= 5.5%

c) actual amount raised = Amount required/ 1- flotation cost

actual amount raised= 24000,000/(1-0.055)

=$ 25,396,825.40

True cost= 25,396,825.40- 2400,0000

= $1396,825.40

If whole amount is raised by debt, the true cost will be lesser since flotation cost of debtis lower.