Question

Trower Corp. has a debt–equity ratio of .90. The company is considering a new plant that will cost $105 million to build. When the company issues new equity, it incurs a flotation cost of 7.5 percent. The flotation cost on new debt is 3 percent.

What is the initial cost of the plant if the company raises all equity externally? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Initial cash flow

$

What is the initial cost of the plant if the company typically uses 60 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Initial cash flow

$

What is the initial cost of the plant if the company typically uses 100 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

Initial cash flow

$

Answer 1

If a company raises all capital externally:

Initial cost = plant cost  + flotation cost.

debt Share = 0.9 / (1 + 0.9) = 0.47.

equity Share = 1 - 0.47 = 0.53.

Weighted average flotation cost = 0.47 * 3% + 0..53 * 7.5% = 5.39%.

initial cost = 100 * (1 + 5.39%) = $105.39 million.

If the firm uses 60% of retained earnings,

then it only needs to raise 40% of the cost of the plant, 100 * 40% = $40 million.

Initial cost = 40 * (1 + 5.39%) = $42.18 million.

Total cost = 60 +42.18 = 102.18 million.

If the firm typically uses 100% of retained earnings,

then it does not require to raise external funds . The initial cost is simply the cost of the plant, i.e., $100 million.