Problem 14-29 Flotation Costs [LO4] Sheaves Corp. has a debt-equity ratio of .8.
ID: 2805097 • Letter: P
Question
Problem 14-29 Flotation Costs [LO4] Sheaves Corp. has a debt-equity ratio of .8. The company is considering a new plant that will cost $118 million to build. When the company issues new equity, it incurs a flotation cost of 8.8 percent. The flotation cost on new debt is 4.3 percent What is the initial cost of the plant if the company raises all equity externally? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) Initial cash flow What is the initial cost of the plant if the company typically uses 55 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) Initial cash flow What is the initial cost of the plant if the company typically uses 100 percent retained earnings? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to the nearest whole dollar amount, e.g., 32.) Initial cash flowExplanation / Answer
Debt Ratio, wd = D/E / (1 + D/E) = 0.8 / (1 + 0.8) = 44.44%
Equity Ratio, we = 1 - wd = 1 - 44.44% = 55.56%
Debt Required = 118 x 44.44% = $52,444,444
Equity Required = 118m - 52.44m = $65,555,556
a) With Flotation cost of 4.3%, debt capital raised = 52,444,444 x (1 + 4.3%) = $54,699,556
If 100% equity is raised externally with 8.8% flotation cost, equity capital raised = 65,555,556 x (1 + 8.8%) = $71,324,444
Initial Cost = 71,324,444 + 54,699,556 = $126,024,000
b) With 55% retained earnings, only 45% of equity will be newly raised, i.e. 45% x 65.55m = $29,500,000
and retained earnings = $65.55 x 55% = $36,055,556
With flotation cost, new equity raised = $29,500,000 x (1 + 8.8%) = $32,096,000
Initial Cost = 54,699,556 + 32,096,000 + 36,055,556 = $122,851,111
c) With 100% retained earnings,
initial cost = $65,555,556 + $54,699,556 = $120,255,111