Pardon Me, Inc., recently issued new securities to finance a new TV show. The pr

Question

Pardon Me, Inc., recently issued new securities to finance a new TV show. The project cost $13.7 million, and the company paid $695,000 in flotation costs. In addition, the equity issued had a flotation cost of 6.7 percent of the amount raised, whereas the debt issued had a flotation cost of 2.7 percent of the amount raised. If the company issued new securities in the same proportion as its target capital structure, what is the company’s target debtequity ratio? (Do not round intermediate calculations and round your final answer to 4 decimal places, e.g., 32.1616.)

Explanation / Answer

Project cost = $13.70 million

Floatation costs paid = $695,000

Total amount raised = Project cost + Floatation costs = $13,700,000 + $695,000 = $14,395,000

Rate of floatation costs = Floatation costs/Amount raised = $695,000/$14,395,000 = 0.0483 = 4.83%

This is weighted floatation costs for whole business.

Let the weight of debt be D.

Hence weight of equity is (1-D)

Floatation cost of Equity = 6.7%

Floatation cost of debt = 2.7%

Weighted floatation cost = (Weight of equity * Floatation cost of equity) + (Weight of debt * Floatation cost of debt)

0.0483 = 0.067*(1-D) + (0.027*D)

0.0483 = 0.067 – 0.067*D + 0.027D

0.0483 – 0.067 = -0.04D

D = 0.0187/0.04 = 0.4675

E = 1-0.4675 = 0.5325

Target debt-equity ratio = Debt/Equity = 0.4675/0.5325 = 0.8779

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