Question

5.A firm has a target debt/equity ratio of 2 and is considering a new investment project. The project would cost $1M to undertake but the firm has only $250,000 in retained earnings. The remaining $750,000 will be raised by selling bonds. The flotation costs of selling bonds are 5%. The flotation costs of issuing new equity are 12%. The firm has a policy of using only internal financing or debt (or both) for new projects. What is the weighted average flotation cost?

Select one:a. 3.33%b. 6.75%c. 3.75%d. It depends on the yield to maturity.e. None of the above.

Answer 1

Firm's has a target debt/equity ratio of 2

The project cost: $1M, Retained earnings $ 250,000,

Hence, remaining funds to be raised from debt and equity: $ 1,000,000 - $ 250,000= $ 750,000

To maintain Debt/equity equals to 2, bond to be issued: $500,000 & Equity to be issued: $ 250,000

Hence, the weight of New equity: Equity issued / total investment =250,000/ 750,000= 0.333

and the weight of Bond issued: Bond issued / total investment =500,000/ 750,000= 0.667

The flotation costs of selling bonds are 5%. The flotation costs of issuing new equity are 12%.

The weighted average flotation cost: Cost of equity * weight of equity + cost of bond * weight of bond

The weighted average flotation cost: 0.12 * 0.333 + 0.05 * 0.667 = 0.0733 or 7.33%

Hence correct answer is e) None of the above.