Europa Corporation is financing an ongoing construction project.The firm will need $5,000,000 of new capital during each of the next 3 years.The firm has a choice of issuing new debt or equity each year as the funds are needed,or issuing only debt now and equity later.Its target capital structure is 40% debt and 60% equity,and it wants to be at that structure in 3 years,when the project has been completed.Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds.Yearly flotation costs for three separate issues of debt would be 3.0% of the gross amount.Ignoring time value effects,how much would the firm save by raising all of the debt now,in a single issue,rather than in three separate issues?

Question

Quizplus · Accepted Answer

The firm needs $5,000,000 of new capital for each of the next 3 years, totaling $15,000,000. With a target capital structure of 40% debt, the total debt needed is 40% of $15,000,000 = $6,000,000. The flotation cost for a single debt issue is 1.6% of $6,000,000 = $96,000. The yearly flotation cost for three separate issues is 3.0% of $2,000,000 (each year's debt) = $60,000 per year, totaling $180,000 for three years. The savings by raising all the debt now, in a single issue, is $180,000 - $96,000 = $84,000.

Europa Corporation Is Financing an Ongoing Construction Project