Suppose your company needs $16 million to build a new assembly line. Your target

Question

Suppose your company needs $16 million to build a new assembly line. Your target debtequity ratio is 0.60. The flotation cost for new equity is 12 percent, but the flotation cost for debt is only 9 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) Weighted average flotation cost can be calculated as follows

Weighted average flotation cost = Debt weight * Flotation cost of debt + equity weight * Flotation cost of equity

= (0.6 / 1.6 ) * 9% + (1/1.6) * 12% = 10.88%

b) True Cost = Total Cost / (1- Flotation cost)

True Cost = 16 / (1-10.88%) = $ 17.95 million

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