To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,00

Question

To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?

$79,425

$83,606

$88,006

$92,406

$92,406

Explanation / Answer

Answer:

Firm would save $88,006 ($185,566 - $97,560) by raising all of the debt now, in a single issue, rather than in 3 separate issues

Solution and working is as follows

Firm has two options

1)     Issue Debt or Equity Each year as the funds are needed

2)     Issue All Debt Now

1. Calculation of Floatation Cost which a firm will incur each year (for 3 years)

Amount Required for Investment each year = $5,000,000

Debt (40%) = $5,000,000 x 40% = $2,000,000

Yearly floatation Cost @ 3% on gross amount of Debt Proceed

Gross Amount of Debt Proceed = Debt + Floatation Cost ---- Equation

Gross Amount of Debt Proceed = $2,000,000 + 3% of Gross Amount of Debt Proceed

By solving above equation, Gross Amount of Debt Proceed = $2,000,000 / 97% = $2,061,855

Total Flotation Cost for 3 years = 3% of Gross Amount of Debt Proceed x 3 = $2,061,855 x 3 x 3% = $185,566

Calculation of Total Cost when firm issue All Debt Now

Total Amount Required for Investment in 3 years = $5,000,000 x 3 = $15,000,000

Debt 40% = $15,000,000 x 40% = $6,000,000

Gross Amount of Proceed = Debt + Flotation Cost --- Equation

Flotation Cost = 1.60% of Gross Amount of Proceed

By putting flotation cost value in equation, we get

Gross Amount of Proceed = $6,000,000 + 1.60% of Gross Amount of Proceed

Gross Amount of Proceed = $6,000,000 / 98.40% = $6,097,560

Total Flotation Cost = $6,097,560 - $6,000,000 = $97,560

Firm would save $88,006 ($185,566 - $97,560) by raising all of the debt now, in a single issue, rather than in 3 separate issues

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