Suppose your company needs $18 million to build a new assembly line. Your target debt-equity ratio is .7. The flotation cost for new equity is 7 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.What is the true cost of building the new assembly line after taking flotation costs into account ?
Debt and Equity:
For expansion or long term investments, huge funds are mandatory and in order to raise funds, the common sources available to companies are issuing stock and issuing debt. An optimal capital structure is the the one at which the costs of raising capital are minimum. Flotation costs occur when new securities are issued like underwriting fees etc. The debt to equity ratio indicates the proportion of debt and equity used by the company in raising capital.
Answer and Explanation:
The true cost of building the new assembly line after taking flotation costs into account is $19.1002 million or $19.1 million approximately.
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fromChapter 3 / Lesson 18
How does a business figure out the true cost and best means of obtaining capital? In this lesson, we will explore the cost of capital, flotation cost, net present value, and internal equity to help answer that question.