Question

Banana Co. has a debt to equity ratio of 0.40. The company is considering a new plant that will cost $150 million to build. When the company issues new equity, it incurs a flotation cost of 8%. The flotation cost on new debt is 3%.

Calculate the weighted average flotation costs. (Enter percentages as decimals and round to 4 decimals)

Calculate the cost of the plant including flotation costs. (Round to 2 decimals)

Answer 1

Current debt to equity ratio of the firm is 0.40 i.e Debt/ equity = 0.40

( 40 :100) - debt and equity is in ratio 2 : 5

Let us assume for raising the funds for building new plant the firm wants to maintain the same debt to equity ratio as before.

weighted average flotation cost = Wd* FCd + We *FCe

where,

wd = weight of debt = 2/7

FCd = Flotation cost of debt = 3%

we = weight of equity = 5/7

FCe = Flotation cost of equity = 8 %

Putting all these values in the equation we get,

Weighted average flotation cost = 6.5714%

Cost of the plant including flotation costs = $150 m + 150*6.5714%

= $ 159.8571 million