Question

A company is considering a project which has an initial startup cost of $783,534. The firm maintains a debt-to-equity ratio of 1.10. The flotation cost of debt is 8.45% and the flotation cost of external equity is 12.63%. The firm has sufficient internally generated equity to cover the equity cost of this project. What is the initial cost of the project including the flotation costs? $797,759 $818,215 $838,670 $859,125 $879,581

Answer 1

Total Capital = $ 783534

Debt-equity ratio= 1.10

Let us suppose we raise $ 2.10 then we would have to raise $ 1 from Equity and $ 1.10 from debt.

Equity portion = total capital to be raised * Equity ratio/( Equity + Debt)

= 783534 * 1/(1+1.10) = 783534/2.10 = $ 373111.40

Same way debt portion = 783534 * 1.10/(1+1.10) = $ 410422.60

Now since our equity is internally generated there will not be any floatation cost for equity, But the debt would have the floatation cost.

Floatation cost of debt is 8.45%

So Debt to be raised = Amount required for investment * (1+Floatation cost %)

= 410422.60 * (1+8.45%)

= $ 445103.30

So total cost of the project is

373111.40 + 445103.30

$ 818214.71 or $ 818215

So 2nd option is the correct answer.