Question

Southern Alliance Company needs to raise $75 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt. Flotation costs for issuing new common stock are 7 percent, for new preferred stock, 4 percent, and for new debt, 3 percent. What is the true initial cost figure Southern should use when evaluating its project?

Answer 1

The initial cost is computed as shown below:

= Amount to be raised / (1 - Weighted average flotation cost)

The Weighted average flotation cost is computed as follows:

= cost of debt x weight of debt + cost of preferred stock x weight of preferred stock + cost of common equity x weight of common equity

= 0.03 x 0.25 + 0.04 x 0.05 + 0.07 x 0.70

= 5.85% or 0.0585

So, the cost will be computed as follows:

= $ 75,000,000 / (1 - 0.0585)

= $ 79,660,116.83

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