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Chapter 15: Problem 19

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?

Short Answer

Expert verified
The true initial cost that Western Alliance Company should use when evaluating its project is \(\$ 13,208,414\).

Step by step solution

01

Calculate the amount raised by each component of the capital structure

First, we need to calculate the amount to be raised by each component of the capital structure based on the target percentages: - Common stock: \[0.60 \times \$12,000,000 = \$ 7,200,000\] - Preferred stock: \[0.10 \times \$12,000,000 = \$ 1,200,000\] - Debt: \[0.30 \times \$12,000,000 = \$ 3,600,000\]
02

Calculate the initial amount raised after taking flotation costs into account

Now that we know the amount raised by each component, we can calculate the amount raised after considering the flotation costs. We do this by dividing the amount raised by 1 minus the corresponding flotation cost for each component: - Common stock (with flotation cost): \[\$ 7,200,000 / (1 - 0.12) =\$ 8,181,818\] - Preferred stock (with flotation cost): \[\$ 1,200,000 / (1 - 0.06) = \$ 1,276,596\] - Debt (with flotation cost): \[\$ 3,600,000 / (1 - 0.04) = \$ 3,750,000\]
03

Calculate true initial cost

Now, we can calculate the true initial cost of the project by adding the initial amounts raised for each component after accounting for the flotation costs: - True initial cost: \[\$ 8,181,818 + \$ 1,276,596 + \$ 3,750,000 = \$ 13,208,414\] So, the true initial cost that Western Alliance Company should use when evaluating its project is \(\$ 13,208,414\).

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Key Concepts

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

Capital Structure
Capital structure is like a blueprint for a company's financial foundation. It describes how a company funds its operations and growth. Typically, it is composed of three main components: **common stock**, **preferred stock**, and **debt**.
  • Common stock represents ownership in the company and can be traded on the stock market.
  • Preferred stock is a hybrid security, possessing qualities of both equity and debt, often with fixed dividends.
  • Debt includes loans and bonds, which are borrowed funds that need to be repaid with interest.
Each component in the capital structure carries different costs and risks. Thus, choosing the right mix is crucial for maximizing a company's value while managing financial risk.
Common Stock
Common stock is an essential part of a company's capital structure. When you own common stock, you own a piece of the company. This ownership allows you to:
  • Vote in shareholder meetings.
  • Receive dividends if the company decides to distribute them.
However, common stock comes with its risks. For instance, if a company goes bankrupt, common stockholders are the last to be paid after debt holders and preferred stockholders. In terms of costs, issuing common stock involves **flotation costs**, which are expenses related to the process of issuing and selling the stock. These costs can be substantial, as demonstrated in the Western Alliance Company example where 12% of the amount raised is lost to flotation expenses.
Preferred Stock
Preferred stock serves as a compromise between common stock and debt. It usually offers investors fixed dividend payments before any dividends can be issued to common stockholders. Therefore, it's often deemed a less risky investment compared to common stock.
Preferred stockholders have a few advantages:
  • Priority over common stockholders in receiving dividends.
  • Ahead in line for assets in the event of a company's liquidation.
Yet, like common stock, issuing preferred stock incurs flotation costs. These are typically lower than those for common stock, as seen in the Western Alliance鈥檚 case where the flotation cost is 6%.
Project Evaluation
Evaluating a project involves determining whether it is worth investing in. Companies must look at various factors, and the **true cost** of raising funds is one of them. In the case of Western Alliance Company, calculating the true initial cost of starting a project involves considering flotation costs. These are costs associated with issuing new stocks or debt.
Project evaluation doesn't stop at adding up these costs. It also involves an assessment of expected cash flows, risks, and the overall potential return on investment. By closely examining all these factors, companies can make informed decisions about whether to proceed with a project or not.

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Most popular questions from this chapter

Calculating cost of Equity The Wind Rider Co. just issued a dividend of \(\$ 2.10\) per share on its common stock. The company is expected to maintain a constant 7 percent growth rate in its dividends indefinitely. If the stock sells for \(\$ 40\) a share, what is the company's cost of equity?

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?

Finding the WACC Titan Mining Corporation has 8 million shares of common stock outstanding, .5 million shares of 6 percent preferred stock outstanding, and 100,0009 percent semiannual bonds outstanding, par value \(\$ 1,000\) cach. The common stock currently sells for \(\$ 32\) per share and has a beta of 1.15 the preferred stock currently sells for \(\$ 67\) per share, and the bonds have 15 years to maturity and sell for 91 percent of par. The market risk premium is 10 percent, T-bills are yielding 5 percent, and Titan Mining's tax rate is 35 percent. a. What is the firm's market value capital structure? b. 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?

WACC Sniffles, Inc., has a target debt-cquity ratio of .90. Its WACC is 13 percent, and the tax rate is 35 percent. a. If Sniffles' cost of equity is 18 percent, what is its pretax cost of debt? b. If instead you know that the aftertax cost of debt is 7.5 percent, what is the cost of equity?

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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