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Long Term Financial Management

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Suppose your company needs $12 million to build a new assembly line. Your target debt-equity ratio is 0.91. The flotation cost for new equity is 9 percent, but the flotation cost for debt is only 3.5 percent.

1) What is your company's weighted average flotation cost, assuming all equity is raised externally?

2) What is the true cost of building the new assembly line after taking flotation costs into account?

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Solution Summary

Flotation costs effect the true value of capital. The solution to the given problem describes the steps to estimate the weighted average of flotation cost and then calculate the true cost of building a new assembly line.

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Debt to equity ratio = D/E = 0.91

Adding 1 to both sides, we get
1 + (D/E) = 1 + 0.91
(D + E)/E = 1.91

(D + E) = E*1.91
E/(D+E) = 1/1.91 = 0.5236

Weight of equity = we = ...

Solution provided by:
Lokesh Jain, MSc
Education
  • BEng (Hons) , Birla Institute of Technology and Science, India
  • MSc (Hons) , Birla Institute of Technology and Science, India
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