Can someone please help me in answering this question...A firm must externally raise $25 million for a new project. The flotation costs for selling debt and equity are 4 percent and 12 percent, respectively. The firm has a target debt-to-equity ratio of 50 percent. If the firm considers flotation costs, how much capital must the firm raise for the new project?

I am not too sure how to proceed. This is what I have so far---->

4% of $25M = $1M flotation cost for debt.

12% of $25M = $3M flotation cost of equity

Total flotation cost = $4M

So firm has to raise 4 + 25 = $29M.

My answer is wrong according to the textbook. Can someone help me out? Thanks

  • I'm sure this will be closed as it's not related to personal finance, but if you have to raise $25mm total, you wouldn't raise $25mm of debt AND of equity. You'd blend the two, or choose one exclusively. With that in mind your total float cost assumption is too high because at $4mm you're raising $50mm total. – quid Mar 11 '16 at 20:33

If it's raising $25 million with a debt to equity ratio of 50% then it's raising $8.33 million of debt and $16.67 million of equity. You've priced it as if it were raising $25 million of debt and $25 million of equity, which would be raising $50 million with a debt to equity ratio of 100%.

  • wow thank you Duke and Mike .... @DukeLuke the answer now makes sooo much sense thanks for the detailed explanation – okocj Mar 11 '16 at 21:43

Your company wants to raise $25,000,000 for a new project, but flotation costs are incurred by issuing securities (underwriting, legal fees, etc)

First you must determine how much of the $25,000,000 is going to be debt and equity. The company's target D/E ratio is 50% (or .50).

For every $0.50 of debt raised they want to raise $1.00 in equity.

$1.00 + $0.50 = $1.50

$0.50/$1.50 = 1/3 debt, that leaves the equity portion being 2/3.

$25,000,000 * (1/3) = $8,333,333.33 (DEBT)

and $25,000,000 * (2/3) = $16,666,666.67 (EQUITY)

Using the Weighted Average Cost then you would do something like this:

= (1/3) * .04 + 2/3 * .12

= .09333333

=$25,000,000/(1-.093333) = $27,573,529.40

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