Question

When we adjust the WACC to reflect flotation costs, this approach: raises each capital source's effective cost. raises only the cost of external equity. reduces the cost of debt. reduces each capital source's effective cost.

Answer 1

When we adjust the WACC to reflect the flotation costs :

It increases each capital sources's effective cost.

So, the correct option is option 1.

For example:

We adjust the cost of common stock by the flotation costs:

Re = D1/ (Po - f) + g

When we adjust the preference capital y the flotation costs :

Rp = Dp / (Po - f)

The adjustment of flotation costs in bonds where the par value is $1000, flotation costs is 3% of the market value . The bond is selling for $1050. the coupon rate is 5%.

FV = $1000

PV = $1050 - 30.5

=$1018.5

N = 10 years

PMT = 50

So, now we can calculate the cost of debt which is higher than the cost of debt calculated previously.

So, it raises each capital sources effective cost.