To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,00
ID: 2709237 • Letter: T
Question
To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?
$79,425
$83,606
$88,006
$92,406
$92,406
Explanation / Answer
Answer:
Firm would save $88,006 ($185,566 - $97,560) by raising all of the debt now, in a single issue, rather than in 3 separate issues
Solution and working is as follows
Firm has two options
1) Issue Debt or Equity Each year as the funds are needed
2) Issue All Debt Now
1. Calculation of Floatation Cost which a firm will incur each year (for 3 years)
Amount Required for Investment each year = $5,000,000
Debt (40%) = $5,000,000 x 40% = $2,000,000
Yearly floatation Cost @ 3% on gross amount of Debt Proceed
Gross Amount of Debt Proceed = Debt + Floatation Cost ---- Equation
Gross Amount of Debt Proceed = $2,000,000 + 3% of Gross Amount of Debt Proceed
By solving above equation, Gross Amount of Debt Proceed = $2,000,000 / 97% = $2,061,855
Total Flotation Cost for 3 years = 3% of Gross Amount of Debt Proceed x 3 = $2,061,855 x 3 x 3% = $185,566
Calculation of Total Cost when firm issue All Debt Now
Total Amount Required for Investment in 3 years = $5,000,000 x 3 = $15,000,000
Debt 40% = $15,000,000 x 40% = $6,000,000
Gross Amount of Proceed = Debt + Flotation Cost --- Equation
Flotation Cost = 1.60% of Gross Amount of Proceed
By putting flotation cost value in equation, we get
Gross Amount of Proceed = $6,000,000 + 1.60% of Gross Amount of Proceed
Gross Amount of Proceed = $6,000,000 / 98.40% = $6,097,560
Total Flotation Cost = $6,097,560 - $6,000,000 = $97,560
Firm would save $88,006 ($185,566 - $97,560) by raising all of the debt now, in a single issue, rather than in 3 separate issues