Capital Requirement, Floatation Costs, and Factors to Consider for Financing - Finance

This article covers the capital requirement and floatation costs for seasonal equity and straight debt financing. It also highlights the factors to consider for financing, such as current money supply and prevailing interest rate. Additionally, it discusses the maximum change in total deposit and yield of bonds, including the calculation of maturity risk premium and default risk premium.

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Question 1
(a) Capital requirement = $100 million
For seasonal equity, the floating cost would be 4.2% of the total capital raised.
Hence,
¿ 4.2 % of capital requirement
¿ 4.2 %∗$ 100 million
Floatation costs=$ 4.2 million
(b) Floatation costs that the Sprite Toy Company would incur if the financing has done through
issuing straight debt only is indicated below.
For straight debt, the floating cost would be 2.3% of the total capital raised.
Hence,
¿ 2.3 % of capital requirement
¿ 2.3 %∗$ 100 million
Floatation costs=$ 2.3 million
(c) Sprite Toy Company has decided to keep the flotation cost low for which the straight debt
should be taken into consideration. The other relevant factors rather than floatation costs that
the company should take are highlighted below.
 Current Money Supply – This is imperative as it would impact the cost of funds and the
return expected by the financers.
 Prevailing Interest Rate – This is one of the main aspects which would determine the cost of
financing and has to be considered.
Question
1

Maximum change in the total deposit when the deposit amount at financial institutions was
initially dropped by $120 billion is computed as shown below.
a) Reserve requirement applicable to deposit was 5%
Maximum change in the total deposit = $120 billion * 95%= $114 billion
b) Reserve requirement applicable to deposit was 10%
Maximum change in the total deposit = $120 billion * 90%= $108 billion
c) Reserve requirement applicable to deposit was 50%
Maximum change in the total deposit = $120 billion * 50%= $60 billion
d) Reserve requirement applicable to deposit was 100%
Maximum change in the total deposit = $120 billion * 0%= Nil
Question 2
Risk free rate of return = 3%
Inflation is expected to average = 2.5% p.a.
Rate of return = 5.6%
Maturity period of bond A =10 years
Maturity period of bond B =5 years
Here,
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MRP = maturity risk premium
DRP = default risk premium.
Yield of bond = Risk free rate + inflation rate + default risk premium + maturity risk premium +
liquidity premium
(1) Bond A has rate of return (rA) which is equal to 8%
Yield of bond = Risk free rate + inflation rate + default risk premium + maturity risk premium +
liquidity premium
8 %=3 % +2.5 %+ DRP + ( 10∗MRP ) … … … … …. (1)
(2) Bind B has rate of return (rB) which is equal to 7.5%
Yield of bond = Risk free rate + inflation rate + default risk premium + maturity risk premium +
liquidity premium
7.5 %=3 %+ 2.5 %+ DRP+ ( 5∗MRP ) … … … … … .(2)
Subtract eq. (2) – eq. (1)
8 %−7.5 %=10 MRP−5 MRP
MRP=0.5 %
5 =0.1 % p . a .
Now,
8 %=3 %+2.5 %+ DRP + ( 10∗0.1% )
8 %=5.2 %+ DRP+1 %
DRP=1.5 %
Therefore, the annual MRP is 0.1% and the DRP associated with the corporate bonds is 1.5%.
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