Sheaves Corp. has a debt-equity ratio of .8. The company is considering a new pl

Question

Sheaves Corp. has a debt-equity ratio of .8. The company is considering a new plant that will cost $112 million to build. When the company issues new equity, it incurs a flotation cost of 8.2 percent. The flotation cost on new debt is 3.7 percent. What is the initial cost of the plant if the company raises all equity externally? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) What is the initial cost of the plant if the company typically uses 55 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) What is the initial cost of the plant if the company typically uses 100 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.)

Explanation / Answer

The debt/equity ratio of the company is 0.8, which means that debt is 0.8/1.8 and equity is 1/1.8. The answers are worked out on the assumption that this D/E will be maintained for raising funds for the new investment. Only the composition of the equity portion is varied as between retained earnings and new equity.

1) The average floation cost if the company raises equity externally, but still keeps the D/E ratio of 0.8, is 8.2*1/1.8 + 3.7*0.8/1.8 = 6.20%

The initial cost will be 112,000,000/(1 - 0.062) = $119,402,985

2) If 55% of equity is retained earnings and the company keeps the D/E of 0.8, the average floatation cost is

    8.2*0.45/1.8 + 0*0.55/1.8 + 3.7*0.8/1.8 = 3.6944%

The initial cost will be 112,000,000/(1-0.036944) = $116,296,456

3) If equity is raised 100% internally, the D/E ratio remaining 0.8, the average floatation cost will be 0*1/1.8 + 3.7*0.8/1.8 = 1.644444%

The initial cost will be 112,000,000/(1 - 0.0164444) = 113,872,566

   

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