Question

Jojo Corp. has a debt–equity ratio of .85. The company is considering a new plant that will cost $145 million to build. When the company issues new equity, it incurs a flotation cost of 8 percent. The flotation cost on new debt is 3.5 percent. What is the initial cost of the plant if the company raises all equity externally? What if it typically uses 60 percent retained earnings? What if all equity investments are financed through retained earnings?

Answer 1

Equty portion of plant =Cost of Plant*1/(1+Debt Equity Ratio) =145/(1+0.85) =78.378378
Debt Portion =145-78.378378 =66.621622
Initial Cost of plant if all is raised through equity externally =Initial Cost+Equity*Flotation Cost+Debt*flotation Cost
=145+78.378378*8%+66.621622*3.5% =153.60 Million or 153,602,027.04

If 60% percent is retained earnings then
Initial Cost of plant =Initial Cost+40%*Equity*Flotation Cost+Debt*flotation Cost
=145+40%*78.378378*8%+66.621622*3.5% =149.84 Million or 149,839,864.88

If  all equity investments are financed through retained earnings then
Initial Cost of plant =Initial Cost+Debt*flotation Cost
=145+66.621622*3.5% =147.33 Million or 147,331,756.77