Suppose your company needs $17 million to build a new assembly line. Your target

Question

Suppose your company needs $17 million to build a new assembly line. Your target debt-equity ratio is 0.65. The flotation cost for new equity is 6 percent, but the flotation cost for debt is only 3 percent. Your boss has decided to fund the project by borrowing money because the flotation costs are lower and the needed funds are relatively small. a. What is your company's weighted average flotation cost, assuming all equity is raised externally? b. What is the true cost of building the new assembly line after taking flotation costs into account?

Explanation / Answer

a.

The weighted average floatation cost is the weighted average of the floatation costs for debt and equity, so:

Debt-equity ratio = 0.65

Debt + Equity = 0.65 + 1 = 1.65

Weight of debt = 0.65/1.65

Weight of equity = 1/1.65

Weighted average floatation costs = 0.03(0.65/1.65) + 0.06(1/1.65) = 0.0118 + 0.0364 = 0.0482 = 4.82%

b.

Amount required = $17 million

Floatation cost = 4.82%

Amount to be raised = $17 million / (1 – 0.0482) = $17 million/0.9518 = $17,860,895.15

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