If a firm has flotation costs of 20% and does not want to pay more than 17% return for a particular security issue. What rate of return is the firm willing to offer the investor?

Question

Quizplus · Accepted Answer

The firm is willing to offer an investor a rate of return that, after accounting for the 20% flotation costs, does not exceed their maximum desired return of 17%. To find this rate, we calculate 17% / (1 - 20%) = 17% / 0.8 = 21.25%. However, the flotation costs are the additional costs the firm incurs, not what the investor receives. The correct calculation to find what the firm is willing to offer, given it absorbs the flotation costs, is to take the desired return of 17% and adjust it for the flotation costs. This means the firm is willing to offer a rate that, after being reduced by the flotation costs, equals a 17% return to the firm. The correct calculation should find the rate that effectively gives the investor a return that, when 20% is taken out as flotation costs, leaves the firm with its desired return. The correct answer, considering the misunderstanding in explanation, is actually 13.6%, which is calculated by taking the desired return and adjusting for the fact that it represents 80% (100% - 20% flotation costs) of what the investor receives: 17% / 0.8 = 21.25%. However, this calculation reflects the total cost to the firm, not the rate offered to the investor. The correct answer, B, reflects a misunderstanding in the explanation process. The firm wants to ensure that after flotation costs, the cost of capital remains at 17%. The correct approach to find the rate before flotation costs would adjust the desired rate to account for these costs, but the explanation provided mistakenly calculates the total cost to the firm, not the rate offered to the investor. The correct answer should reflect the rate the firm offers before flotation costs, aiming to achieve a net cost of capital of 17% after those costs.

If a Firm Has Flotation Costs of 20% and Does