Hartley Psychiatric, Inc. needs to purchase office equipment for its 2000 drive-

Question

Hartley Psychiatric, Inc. needs to purchase office equipment for its 2000 drive-in therapy centres. The total cost of the equipment is $2,000,000. It is estimated that the after-tax cash inflows from the project will be $210,000 annually forever. Hartley has a debt-to-value (both market values) ratio of 40%. The firm’s cost of equity is 13% and its pre-tax cost of debt is 8%. The flotation costs of debt and equity are 2% and 8%, respectively. Assume the firm’s tax rate is 34%.

What is the dollar flotation cost for the proposed financing?

1. $112,000
2. $118,644
3. $131,230
4. $142,098
5. $159,001

Explanation / Answer

According to the given problem, Cost of the equipment is $2,000,000 Weight of the debt is 40% Weight of equity is (1 – 40%) = 60% Cost of equity is 13% After-tax cost of debt = Pre-tax cost of debt (1 – Tax rate) = 0.08 (1 - 0.34) = 0.0528 or 5.28% Flotation costs for debt (fD) = 2% Flotation costs for equity (fE) = 8% Calculating the total flotation costs for the proposed project is Total Flotation costs (fA) = Weight of equity x fE + Weight of debt x fD = 0.6 x 0.08 + 0.4 x 0.02 = 0.048 + 0.008 = 0.056 or 5.6% Therefore the weighted average flotation costs is thus 5.6% Calculating the flotation costs on the total cost of the project = 5.6% x $2,000,000 = $112,000 Therefore, the correct option is $112,000

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