Question

Thinking Hat would like to start a new project which will require $27 million in the initial cost. The company is planning to raise this amount of money by selling new corporate bonds. It will generate no internal equity for the foreseeable future. Thinking Hat has a target capital structure of 55 percent common stock, 11 percent preferred stock, and 34 percent debt. Flotation costs for issuing new common stock are 10 percent, for new preferred stock, 9 percent, and for new debt, 5 percent. What is the true required initial investment that the company should use in its valuation of the project? (Do not round your intermediate calculations.)

rev: 09_20_2012

$29,408,561

$29,211,300

$30,584,903

$28,232,219

$24,840,000

Answer 1

For this question, we first need to calculate the weighted average floatation cost.

Weighted avg floatation cost = (% floatation cost of debt * Weight of Debt) + (% floatation cost of preferred equity * Weight of preferred equity) + (% floatation cost of common equity * Weight of Common Equity)

Weighted avg floatation cost = (5% * 34%) + (9% * 11%) + (10% * 55%) = 8.19%

So, this implies, out of the total capital that is raised, 8.19% would be the floatation cost.

Let the total capital raised be X

X * (1 - 8.19%) = $27mil

X = $29,408,561 --> True required initial investment