Why are a firm's target capital structure values used when computing the average flotation cost for issuing new securities?

• A. Because the target capital structure always matches the firm's current capital structure.
• B. Because the target capital structure is required by accounting standards for all financial calculations.
• C. Because the average flotation cost should reflect the proportion of each type of capital the firm intends to use in the long run.
• D. Because flotation costs are only incurred for equity financing, not for debt.

Answer: (C)

Verified step by step guidance

1. Understand the concept of flotation costs: Flotation costs are the costs incurred by a company when issuing new securities, such as underwriting fees, legal fees, and registration fees. These costs are typically expressed as a percentage of the funds raised.
2. Recognize the importance of the target capital structure: A firm's target capital structure represents the proportion of debt, equity, and other financing sources that the firm aims to maintain in the long run. This structure reflects the firm's strategic financial planning.
3. Relate flotation costs to the target capital structure: The average flotation cost should be calculated based on the firm's target capital structure because it represents the long-term proportions of financing sources. This ensures that the flotation cost calculation aligns with the firm's intended financial strategy.
4. Clarify why the current capital structure is not used: The current capital structure may not accurately reflect the firm's long-term financing goals. Using the target capital structure ensures that the flotation cost calculation is forward-looking and consistent with the firm's strategic objectives.
5. Explain why flotation costs are not limited to equity financing: Flotation costs can apply to both equity and debt financing, depending on the type of securities issued. Therefore, the average flotation cost calculation should account for all types of capital the firm plans to use in its target capital structure.