Sheaves Corp. has a debt-equity ratio of 0.9. The company is considering a new plant that will cost $105 million to build. When the company issues new equity, it incurs a flotation cost of 7.5 percent. The flotation cost on new debt is 3 percent.
a. What is the initial cost of the plant if the company typically uses 100 percent retained earnings?
b. What is the initial cost of the plant if the company typically uses 60 percent retained earnings?
c. What is the initial cost of the plant if the company raises all equity externally?
Firms can raise external capital by issuing new debts or new equities. In either case, they incur flotation costs, which are expenses related to the issuance of new securities. Flotation costs include underwriting fees, legal fees, and other transaction costs. When evaluating investments, these flotation costs need to be added to produce a more accurate estimate of the project's profitability.
Answer and Explanation:
a. If the company raise all equity externally, they will incur the flotation costs. Given a debt-equity ratio of 0.9, the share of equity raise through debt is 0.9/(1 + 0.9) = 0.47, and the share raised by equity is 1 - 0.47 = 0.53. The weighted average flotation cost = 0.47*3% + 0.53*7.5% = 5.385%. This is the extra cost that must be added to the cost of plant.
To raise all 108 million externally, the initial cost = 105*(1 + 5.385%) = 110.65425 million.
b. If the company typically uses 60 percent retained earnings, then the amount of capital that needs to raise externally is 105*(1 - 60%) = 42 million. Incorporating the flotation costs, the initial cost is 105*60% + 42*(1 + 5.385%) = 107.2617 million.
c. If the company uses 100 percent of retained earnings, the it does not need to raise external capital and will incur no flotation costs. The initial cost is 108 million.
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from Corporate Finance: Help & ReviewChapter 3 / Lesson 18