Sheaves Corp. has a debtequity ratio of .85. The company is considering a new pl

Question

Sheaves Corp. has a debtequity ratio of .85. The company is considering a new plant that will cost $104 million to build. When the company issues new equity, it incurs a flotation cost of 7.4 percent. The flotation cost on new debt is 2.9 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 65 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.)

Sheaves Corp. has a debtequity ratio of .85. The company is considering a new plant that will cost $104 million to build. When the company issues new equity, it incurs a flotation cost of 7.4 percent. The flotation cost on new debt is 2.9 percent.

Explanation / Answer

The company is considering new plant for $104 million
Floating cost on equity = 7.4%
Floating cost on debt = 2.9%
Initial cost of plant=Required amount + Floating cost

1. the initial cost of the plant if the company raises all equity externally:
Initial cost of plant=Required amount + Floating cost
=104 + (0.074*104)
=104 + 7.696
=111.696



2. the initial cost of the plant if the company uses 65% retained earnings:
Thus cost raised by retained earning = 104*0.65=67.6
cost raised by new capital = 104-67.6= 36.4
Given,
Debt to equity ratio = 0.85
Thus Debt = 0.85/1.85 = 0.4595
Equity = 1-0.4595 = 0.5405
hence,
New capital raised through debt = 0.4595*36.6 = 16.8177
New capital raised through equity = 0.5405*36.6 = 19.7823

Initial cost of debt=Required amount + Floating cost
=16.8177 + (0.029*16.8177)
=16.8177 + 0.4877
=17.3054

Initial cost of equity=Required amount + Floating cost
=19.7823 + (0.079*19.7823)
=19.7823 + 1.5628
=21.345

Initial cost of plant=Debt+equity+retained earnings
=17.3054+21.345+67.6
=106.2504



3. the initial cost of the plant if the company ruses 100% retained earnings:
Tnitial cost of plant=Required amount + Floating cost
=104 + (0*104)
=104 + 0
=104

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