Southern Alliance Company needs to raise $55 million to start a new project and

Question

Southern Alliance Company needs to raise $55 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 65 percent common stock, 5 percent preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 8 percent, for new preferred stock, 5 percent, and for new debt, 3 percent.

What is the true initial cost figure Southern should use when evaluating its project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

What is the true initial cost figure Southern should use when evaluating its project? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Explanation / Answer

Answer: Calculation of the true initial cost figure Southern should use when evaluating its project:

We first need to find the weighted average flotation cost. Doing so, we find:

f T = .65(.08) + .05(.05) + .30(.03) = .0635, or 6.35%

And the total cost of the equipment including flotation costs is:

Amount raised(1 – .0635) = $55,000,000

Amount raised = $55,000,000 / (1 – .0635) = $58,729,311

Intial cost=$ 58,729,311 ± 0.01%

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