Hartley, Inc. needs to purchase equipment for its 2,000 drive-ins nationwide. The total cost of the equipment is $2 million. It is estimated that the after-tax cash inflows from the project will be $210,000 annually in perpetuity. Hartley has a market value debt-to-assets ratio of 40%. The firm's cost of equity is 13%, its pre-tax cost of debt is 8%, and the flotation costs of debt and equity are 2% and 8%, respectively. The tax rate is 34%. Assume the project is of similar risk to the firm's existing operations.

What is the dollar flotation cost for the proposed financing?

Question

What is the dollar flotation cost for the proposed financing?

Quizplus · Accepted Answer

First, calculate the weighted average cost of capital (WACC) considering the tax shield on debt. The firm's equity-to-assets ratio is 60% (100% - 40%). The after-tax cost of debt is 8% * (1 - 34%) = 5.28%. The WACC is then 0.6 * 13% + 0.4 * 5.28% = 10.112%. To find the value of the project (V), use the formula for perpetuity: V = Cash Flow / WACC. So, V = $210,000 / 0.10112 = $2,077,586.21.The total amount to be financed is $2 million. The proportion of financing through debt is 40%, which is $800,000, and through equity is 60%, which is $1,200,000. The flotation cost for debt is 2% of $800,000 = $16,000, and for equity is 8% of $1,200,000 = $96,000. Therefore, the total flotation cost is $16,000 + $96,000 = $112,000. However, the correct calculation involves recognizing the error in the initial step regarding the use of WACC and perpetuity formula, which was not needed for calculating flotation costs directly from the given percentages and amounts of financing. The correct approach is directly calculating the flotation costs based on the amounts of debt and equity issued and their respective flotation cost rates. Given this, the error in the explanation points to a mistake in the calculation process, and the correct answer should directly relate to the flotation costs associated with the amounts of debt and equity being issued. The correct calculation of flotation costs is directly from the given percentages and amounts without needing to calculate the WACC or use the perpetuity formula, indicating a mistake in the explanation process.