Southern Alliance Company needs to raise $25 million to start a new project and

Question

Southern Alliance Company needs to raise $25 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 55 percent common stock, 9 percent preferred stock, and 36 percent debt. Flotation costs for issuing new common stock are 11 percent, for new preferred stock, 6 percent, and for new debt, 5 percent.

What is the true initial cost figure Southern should use when evaluating its project?

Southern Alliance Company needs to raise $25 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 55 percent common stock, 9 percent preferred stock, and 36 percent debt. Flotation costs for issuing new common stock are 11 percent, for new preferred stock, 6 percent, and for new debt, 5 percent.

What is the true initial cost figure Southern should use when evaluating its project?

Explanation / Answer

Weighted Average Floatation Cost = Wd x Fd + Wp x Fp + We x Fe

= (0.36 x 5%) + (0.09 x 6%) + (0.55 x 11%)

= 1.8% + 0.54% + 6.05% = 8.39%

Amount Raised(1 - F) = Cost of project

Amount Raised(1 - 0.0839) = $25,000,000

Amount Raised = $25,000,000/(1 - 0.0839) = $25,000,000/0.9161 = $27,289,597.21

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