Southern Alliance Company needs to raise $27 million to start a new project and

Question

Southern Alliance Company needs to raise $27 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, 9 percent preferred stock, and 26 percent debt. Flotation costs for issuing new common stock are 13 percent, for new preferred stock, 6 percent, and for new debt, 4 percent. What is the true initial cost figure Southern should use when evaluating its project?

Explanation / Answer

Step 1: Calculate the Weighted Average Flotation Cost

The weighted average flotation cost can be calculated with the use of following formula:

Weighted Average Flotation Cost = Weight of Common Stock*Flotation Cost for Common Stock + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Debt*Cost of Debt

Using the values provided in the question, we get,

Weighted Average Flotation Cost = 65%*13% + 9%*6% + 26%*4% = 10.03%

_______

Step 2: Calculate the True Initial Cost Figure

The true initial cost figure can be calculated as follows:

True Initial Cost Figure = (Total Amount to be Raised Excluding Flotation Costs)/(1-Weighted Average Flotation Cost) = 27,000,000/(1-10.03%) = $30,010,003.33 (answer)

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.