Question

Sheaves Corp. has a debt?equity ratio of .9. The company is considering a new plant that will cost $116 million to build. When the company issues new equity, it incurs a flotation cost of 8.6 percent. The flotation cost on new debt is 4.1 percent.

1)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 dollar amount, e.g., 32.)

2)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 dollar amount, e.g., 32.)

3)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 dollar amount, e.g., 32.)

Answer 1

1). Initial cost of the plant = $116 million * 1.086 = $125,976,000

2). Debt to capital "D/C" = D/E / (1 + D/E) = 0.9 / 1.9 = 0.47368
thus, equity to capital is (1 - D/C) = 0.52632

  cost financed from retained earnings: 116m * 0.6 = $69,600,000
remainder to finance with new capital: 116m - 69.6m = $46,400,000

  if that amount is financed at the same debt and equity proportions as the existing capital structure...
46,400,000 * 0.47368 = $21,978,752 needs to be raised from debt,

thus the cost of that is: $21,978,752 * 1.041 = $22,879,880.83 and

46,400,000 * 0.52632 = $24,421,248 will need to be raised from new equity,

which will cost: 24,421,248 * 1.086 = $26,521,475.33

  For a total cost of: 69,600,000 + 22,879,880.83 + 26,521,475.33 = $119,001,356.20

3). Initial cost of the plant = $116 million