Ppose your company needs $10 million to build a new assembly line. Your target debt-equity ratio is .3. The flotation cost for new equity is 6 percent and the flotation cost for debt is 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 the flotation costs into account?

Explanation:

± 0.01%

a.The weighted average flotation cost is the weighted average of the flotation costs for debt and equity, so:

fT= 0.03(0.30/1.60) + 0.06(1/1.60) =0.0431, or 4.31%

b. The total cost of the equipment including flotation costs is:Amount raised(1 –0.0431 ) = $10,000,000

Amount raised = $10,000,000/(1 – 0.0688) = $10,460,251

Even if the specific funds are actually being raised completely from debt, the flotation costs, and hence true investment cost, should be valued as if the firm’s target capital structure is used.

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