Question

Suppose your company needs $17 million to build a new assembly line. Your target debt-equity ratio is 0.81. The flotation cost for new equity is 9.5 percent, but the flotation cost for debt is only 4.5 percent.

Requirement 1:

What is your company’s weighted average flotation cost, assuming all equity is raised externally? (Round your answer to 2 decimal places. (e.g., 32.16))

Weighted average flotation cost

%

Requirement 2:

What is the true cost of building the new assembly line after taking flotation costs into account? (Round your answer to the nearest whole dollar amount. (e.g.,1,234,567))

  

True cost

$

Answer 1

Answer to Requirement 1:

Weighted Average Flotation Cost = Weight of Debt * Flotation Cost of Debt + Weight of Equity * Flotation Cost of Equity
Weighted Average Flotation Cost = (0.81/1.81) * 4.50% + (1.00/1.81) * 9.50%
Weighted Average Flotation Cost = 7.26%

Answer to Requirement 2:

True Cost of Building * (1 - Weighted Average Flotation Cost) = Amount Needed
True Cost of Building * (1 - 0.0726) = $17,000,000
True Cost of Building * 0.9274 = $17,000,000
True Cost of Building = $18,330,817