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Chapter 15: Problem 18

Calculating Flotation costs Suppose your company needs \(\$ 6\) million to build a new assembly line. Your target debt-equity ratio is \(1.0 .\) The flotation cost for new equity is 15 percent, but the flotation cost for debt is only 4 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 do you think about the rationale behind borrowing the entire amount? b. What is your company's weighted average flotation cost? c. 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?

Short Answer

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a) The rationale behind borrowing the entire amount is mainly due to lower flotation costs associated with debt (4%), as opposed to equity (15%). However, this decision can affect the company's target debt-equity ratio. b) The weighted average flotation cost is 9.5%. c) The true cost of building the new assembly line is $6,629,834.25 after taking into account flotation costs. The decision of raising the entire amount from debt might affect the company's capital structure and target debt-equity ratio.

Step by step solution

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1. Rationale Behind Borrowing the Entire Amount

The rationale behind borrowing the entire amount can be justified by looking at the lower flotation costs associated with the debt as compared to the equity, which comes with 15% flotation costs. Also, the needed funds are relatively small, making it easy for the company to handle the debt. However, this decision might conflict with the company's target debt-equity ratio, as it changes the capital structure.
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2. Calculating Weighted Average Flotation Cost

Let's denote the flotation cost for equity as F_e and the flotation cost for debt as F_d. Similarly, let's denote the weightage of equity as W_e and the weightage of debt as W_d. To calculate the Weighted Average Flotation Cost (WFC), we need to multiply each flotation cost by their respective proportions and sum them up: Weighted Average Flotation Cost (WFC) = W_e * F_e + W_d * F_d Given the target debt-equity ratio of 1.0, both debt and equity have the same weightage (W_e = W_d = 0.5). WFC = 0.5 * 15% + 0.5 * 4% = 0.5 * 0.15 + 0.5 * 0.04 = 0.075 + 0.02 = 0.095 or 9.5%
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3. True Cost of Building the New Assembly Line

Now that we have the weighted average flotation cost (9.5%), we can calculate the true cost of building the new assembly line. The amount needed is $6 million. Therefore, the true cost can be found using the following formula: True Cost = Amount Needed / (1 - WFC) True Cost = 6,000,000 / (1 - 0.095) = 6,000,000 / 0.905 = \$ 6,629,834.25 It is important to consider that the entire amount being raised from debt will affect the company's capital structure, and, as a result, its weighted average flotation cost. Depending on the capital structure and company targets, it may or may not matter that the entire amount is being raised from debt. To summarize: a) The rationale behind borrowing the entire amount is mainly due to lower flotation costs associated with debt (4%), as opposed to equity (15%). However, this decision can affect the company's target debt-equity ratio. b) The weighted average flotation cost is 9.5%. c) The true cost of building the new assembly line is \$6,629,834.25 after taking into account flotation costs. The decision of raising the entire amount from debt might affect the company's capital structure and target debt-equity ratio.

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Key Concepts

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

Debt-Equity Ratio
The debt-equity ratio is a key component in understanding a company's financial structure. It reflects the relative proportions of debt and equity that the company uses to finance its operations. When a company has a target debt-equity ratio of 1.0, it means the company aims to have an equal amount of debt and equity. This balance can be crucial for maintaining financial health and achieving strategic goals.

Calculating the debt-equity ratio is straightforward: it's the total debt of the company divided by the total equity. A higher ratio generally means more debt, and a lower ratio indicates more equity. Each comes with its advantages: debt often costs less due to tax advantages and lower flotation costs, but it may also increase financial risk. Conversely, equity might dilute ownership but doesn't require fixed payments like debt.
  • Pros of Debt: Often has lower flotation costs and tax benefits.
  • Cons of Debt: Higher financial risk due to obligatory interest payments.
  • Pros of Equity: No obligatory payments, less financial strain in lean times.
  • Cons of Equity: Higher flotation costs, potential dilution of ownership.
Capital Structure
Capital structure refers to how a company finances its overall operations and growth through different sources of funds. It's a mix of debt, equity, or hybrid securities. Each company aims to optimize its capital structure to manage risk and enhance value. A company鈥檚 capital structure must align with its strategic goals and risk tolerance to ensure long-term success.

A balanced capital structure can lower the cost of capital, thus boosting profitability. It can offer financial flexibility and the capability to survive economic downturns. For instance, utilizing more debt can reduce tax liability due to interest tax shields, potentially increasing the company's net income after taxes.

The challenge, however, is in maintaining the desired structure. Deviations, such as funding an entire project with debt, can alter the balance between debt and equity, potentially redefining the company鈥檚 risk and return profile. This can lead to changes in leverage, which is the extent to which debt is used in the capital structure, affecting the overall financial stability of the company.
Weighted Average Flotation Cost
Weighted Average Flotation Cost (WAFC) is a measure of the overall cost associated with issuing new securities to finance projects. It considers the respective costs of equity and debt, weighted by their proportion in the capital structure. Flotation costs are incurred when a company issues new securities and include expenses like underwriting fees, legal fees, and registration fees.

To calculate the WAFC, multiply the flotation cost of each financing source by its weight in the capital structure, then sum the results. In the context of a target debt-equity ratio of 1.0, both debt and equity have equal weight, making the calculation straightforward: \[ WAFC = (0.5 \times 0.15) + (0.5 \times 0.04) = 0.075 + 0.02 = 0.095 \text{ or } 9.5\% \]

Understanding weighted average flotation cost helps businesses determine the true cost of capital and make informed financial decisions. Companies aiming to maintain specific target debt-equity ratios must factor in flotation costs to ensure they do not inadvertently shift their financial strategy by increasing fundraising costs.

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Most popular questions from this chapter

Calculating cost of Preferred Stock Holdup Bank has an issue of preferred stock with a \(\$ 5\) stated dividend that just sold for \(\$ 92\) per share. What is the bank's cost of preferred stock?

Flotation costs Salsman, Inc., recently issued new securitics to finance a new TV show. The project cost \(\$ 1.4\) million and the company paid \(\$ 105,000\) in flotation costs. In addition, the equity issued had a flotation cost of 10 percent of the amount raised, whereas the debt issued had a flotation cost of 3 percent of the amount raised. If Salsman issued new securities in the same proportion as its target capital structure, what is the company's target debt- equity ratio?

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An all-equity firm is considering the following projects $$\begin{array}{|ccc|} \hline \text { Project } & \text { Beta } & \text { Expected Return } \\ \hline \mathrm{W} & .70 & 11 \% \\ \mathrm{X} & .95 & 13 \\ \mathrm{Y} & 1.05 & 14 \\ \mathrm{Z} & 1.60 & 16 \\ \hline \end{array}$$ The T-bill rate is 5 percent, and the expected return on the market is 12 percent. a. Which projects have a higher expected return than the firm's 12 percent cost of capital? b. Which projects should be accepted? c. Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate?

Calculating Flotation costs Western Alliance Company needs to raise \(\$ 12\) million to start a new project and will raise the money by selling new bonds. The company has a target capital structure of 60 percent common stock, 10 percent preferred stock, and 30 percent debt. Flotation costs for issuing new common stock are 12 percent, for new preferred stock, 6 percent, and for new debt, 4 percent. What is the true initial cost figure Western should use when evaluating its project?
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