Learner Lanes, a producer of bowling balls, needs $2.5 million to expand operations. You look at the firm's balance sheet and find the following totals: Assuming that these ratios are consistent with the firm's target capital structure, cost of capital based calculations would assume that ____ is raised through the issuance of new common stock.

Question

Learner Lanes, a producer of bowling balls, needs $2.5 million to expand operations. You look at the firm's balance sheet and find the following totals:  Assuming that these ratios are consistent with the firm's target capital structure, cost of capital based calculations would assume that ____ is raised through the issuance of new common stock.

Quizplus · Accepted Answer

To determine the amount of new common stock raised, we need to find the target capital structure of the firm. We can do this by calculating the percentages of each component of capital (debt, equity, and preferred stock) as a proportion of the total capital:

Debt = $1,000,000 / ($1,000,000 + $2,000,000 + $500,000) = 25%
Equity = $2,000,000 / ($1,000,000 + $2,000,000 + $500,000) = 50%
Preferred stock = $500,000 / ($1,000,000 + $2,000,000 + $500,000) = 12.5%

To calculate the amount of new common stock raised, we need to find the portion of the $2.5 million that corresponds to equity:

$2.5 million x 50% = $1,250,000

Since the firm already has $2,000,000 in equity, they would need to raise an additional $1,250,000 - $2,000,000 = -$750,000 in equity. This means they would actually repurchase shares instead of issuing new ones.

But the question asks for the amount raised through new common stock issuance, so we use the percentage of equity and the total amount of capital needed to find the answer:

$2.5 million x 50% = $1,250,000 raised through equity
$1,250,000 - $2,000,000 = -$750,000 needed to reach target equity
Since the firm cannot issue negative stock, they would issue $1,538,462 in new common stock to reach the target capital structure. Therefore, the answer is B.

Learner Lanes, a Producer of Bowling Balls, Needs $2