Question

Southern Star Company needs to raise $40 million to start a new project and will raise the money by selling new bonds. The company will generate no internal equity for the foreseeable future. The company has a target capital structure of 50 percent common stock, 15 percent preferred stock, and 35 percent debt. Flotation costs for issuing new common stock are 8 percent, for new preferred stock, 5 percent, and for new debt, 2 percent. What is the true initial cost figure the company should use when evaluating its project? True initial cost $

Answer 1

First, the Company should calculate the total cost of raising funds. The total cost is calculated below:

(Percentage of common stock ~ Common stock cost) Total cost = 1 +Percentage of preferred stock < Preferred stock cost +Percentage of debtx Debt cost = (50%*8% +15%x5% +35% x 2%) =4%+0.75%+0.7% = 5.45%

5.45% of the amount raised will be the cost of raising funds. So, the actual amount raised will be (100% - 5.45%) = 94.55% of the total amount.

The company can estimate the true initial cost figure by dividing the total raising amount by the actual amount raised percentage.

Total amount raised True initial cost = Actual amount raised percentage $40,000,000 94.55% = $42,305,658.38