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Chapter 13: Problem 17

Calculating Flotation Costs Southern Alliance Company needs to raise \(\$ 45\) 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, 5 percent preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 9 percent, for new preferred stock, 6 percent, and for new debt, 3 percent. What is the true initial cost figure Southern should use when evaluating its project?

Short Answer

Expert verified
The true initial cost figure Southern Alliance Company should use when evaluating its project is \$48,172,500. This includes the total amount needed to raise (\$45,000,000) and the total flotation costs (\$3,172,500) associated with issuing new common stock, preferred stock, and debt.

Step by step solution

01

Calculate proportion of each capital source

Based on the target capital structure, we need to calculate the proportion of common stock, preferred stock, and debt in the total capital raised: - Proportion of common stock: \(65\% \) - Proportion of preferred stock: \(5\%\) - Proportion of debt: \(30\% \)
02

Calculate the amount raised for each capital source

Now, we will calculate the amount of funds that will be raised from each capital source using the given proportions: - Amount raised from common stock: \(\$45,000,000 * 65\% = \$29,250,000 \) - Amount raised from preferred stock: \(\$45,000,000 * 5\% = \$2,250,000 \) - Amount raised from debt: \(\$45,000,000 * 30\% = \$13,500,000 \)
03

Calculate the individual flotation costs

We will now calculate the flotation costs for each capital source using the given flotation cost percentages: - Flotation cost for common stock: \(\$29,250,000 * 9\% = \$2,632,500 \) - Flotation cost for preferred stock: \(\$2,250,000 * 6\% = \$135,000 \) - Flotation cost for debt: \(\$13,500,000 * 3\% = \$405,000 \)
04

Calculate the total flotation costs

Finally, we will sum up the individual flotation costs to find the total flotation costs: Total flotation costs = Flotation cost for common stock + Flotation cost for preferred stock + Flotation cost for debt = \(\$2,632,500 + \$135,000 + \$405,000 \) = \(\$3,172,500 \)
05

Calculate the true initial cost figure

Now, we will add the total flotation costs to the total amount that the company needs to raise to find the true initial cost figure: True initial cost = Total amount needed to raise + Total flotation costs = \(\$45,000,000 + \$3,172,500\) = \(\$48,172,500 \) So, the true initial cost figure Southern should use when evaluating its project is \$48,172,500.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Capital Structure
Capital structure represents the way a company finances its operations and growth through different sources of funds. Companies can fund their projects using various financial instruments.
Each type of funding has a different cost and degree of financial risk.
  • **Equity Financing**: This involves raising money by selling shares of the company, which may include common stock and preferred stock.
  • **Debt Financing**: This includes borrowing money and committing to repay the principal amount along with interest.
A target capital structure is a specific mix or percentage that a company aims to achieve between these different types of funding. For Southern Alliance Company, the target capital structure is 65% common stock, 5% preferred stock, and 30% debt. This mix influences the flotation costs calculated when new capital is raised.
Bonds
Bonds are one form of debt financing wherein investors lend money to a corporation for a defined period at a fixed interest rate.
This debt is traded in the market, making it an attractive option for raising capital.
Southern Alliance Company plans to raise part of its required funds through bond issuance.
Bonds typically come with specific characteristics:
  • **Maturity Date**: The date when the bond's principal amount is repaid to the bondholders.
  • **Coupon Rate**: The interest rate that the bond will pay annually or semi-annually to the bondholder.
  • **Yield**: The return the investor expects based on the bond's purchase price and coupon payments.
When issuing new bonds, companies consider the flotation costs, which are the expenses related to issuing new securities.
Preferred Stock
Preferred stock is a type of equity that provides shareholders with a higher claim on dividends and assets than common stock, but typically without voting rights.
This makes preferred stock a hybrid between debt and equity.
Preferred stockholders often receive dividends before common stockholders and have a fixed dividend rate.
Key features of preferred stock include:
  • **Dividend Preference**: Prioritized dividend payments over common shareholders.
  • **Par Value**: The nominal value of the stock, used to calculate dividends.
  • **Redeemability**: Some preferred stocks can be bought back by the issuing company at a predetermined price after a certain period.
Southern Alliance Company accounts for flotation costs when issuing preferred stock to ensure accurate financial planning.
Common Stock
Common stock represents the equity, or ownership, in a company, providing shareholders with voting rights proportional to the number of shares they hold.
This type of stock is the most prominent form of equity financing.
Shareholders of common stock benefit from:
  • **Voting Rights**: The ability to vote on corporate policies and decisions.
  • **Dividends**: Payments made from the company鈥檚 earnings, although they are not guaranteed.
  • **Capital Gains**: Profits from selling shares at a higher price than the purchase value.
For Southern Alliance Company, common stock accounts for the majority of its capital structure. Yet, flotation costs incurred when issuing new shares are crucial to consider, as they directly impact the company鈥檚 overall financing costs.
Debt Financing
Debt financing involves borrowing funds that must be repaid over time, usually with interest. This can include loans, credit lines, or issuing bonds, which are forms of borrowing not tied to ownership stakes in the company.
Benefits of debt financing include:
  • **Tax Deductibility**: Interest payments on debt are tax-deductible, reducing the company鈥檚 taxable income.
  • **Retaining Ownership**: Unlike equity financing, debt does not dilute the ownership percentages of existing shareholders.
  • **Finite Obligation**: Debt agreements have a fixed term, leading to eventual repayment and no further claims on company earnings.
Debt structuring often involves considering flotation costs, which are associated with arranging and making the debt available for a company like Southern Alliance.

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Most popular questions from this chapter

Calculating Flotation Costs Suppose your company needs \(\$ 20\) million to build a new assembly line. Your target debt-equity ratio is .75. The flotation cost for new equity is 8 percent, but the flotation cost for debt is only 5 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. 1\. What do you think about the rationale behind borrowing the entire amount? 2\. What is your company's weighted average flotation cost, assuming all equity is raised externally? 3\. What is the true cost of building the new assembly line after taking flotation costs into account? Does it matter in this case that the entire amount is being raised from debt?

Calculating Cost of Equity The Dybvig Corporation's common stock has a beta of 1.15. If the risk-free rate is 4.5 percent and the expected return on the market is 11 percent, what is Dybvig's cost of equity capital?

Flotation Costs Goodbye, Inc., recently issued new securities to finance a new TV show. The project cost \(\$ 15\) million, and the company paid \(\$ 850,000\) in flotation costs. In addition, the equity issued had a flotation cost of 7 percent of the amount raised, whereas the debt issued had a flotation cost of 3 percent of the amount raised. If Goodbye issued new securities in the same proportion as its target capital structure, what is the company's target debt- equity ratio?

Calculating Cost of Equity Stock in Country Road Industries has a beta of .85. The market risk premium is 8 percent, and \(T\)-bills are currently yielding 5 percent. The company's most recent dividend was \(\$ 1.60\) per share, and dividends are expected to grow at a 6 percent annual rate indefinitely. If the stock sells for \(\$ 37\) per share, what is your best estimate of the company's cost of equity?

Finding the WACC Titan Mining Corporation has 8.5 million shares of common stock outstanding and \(200,0007.5\) percent semiannual bonds outstanding, par value \(\$ 1,000\) each. The common stock currently sells for \(\$ 34\) per share and has a beta of 1.20, and the bonds have 15 years to maturity and sell for 93 percent of par. The market risk premium is 7 percent, \(T\)-bills are yielding 5 percent, and Titan Mining's tax rate is 35 percent. 1\. What is the firm's market value capital structure? 2\. If Titan Mining is evaluating a new investment project that has the same risk as the firm's typical project, what rate should the firm use to discount the project's cash flows?
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