Question

Pardon Me, Inc., recently issued new securities to finance a new TV show. The project cost $14.4 million, and the company paid $765,000 in flotation costs. In addition, the equity issued had a flotation cost of 7.4 percent of the amount raised, whereas the debt issued had a flotation cost of 3.4 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 debt?equity ratio? PLEASE SHOW ME ALL WORK, I ONLY HAVE THREE QUESTIONS I CAN POST, please provide me with the correct answer. Thank You!

Answer 1

Step 1: Calculate Weighted Average Flotation Cost

The weighted average flotation cost is calculated with the use of following equation:

(Cost of Project + Flotation Cost)*(1-Weighted Average Flotation Cost) = Cost of Project

Using the values provided in the question in the above formula, we get,

(14,400,000 + 765,000)*(1-Weighted Average Flotation Cost) = 14,400,000

Rearranging Values, we get,

Weighted Average Flotation Cost = 1 - 14,400,000/(14,400,000 + 765,000) = 5.04%

_____

Step 2: Calculate Target Debt-Equity Ratio

The target debt to equity ratio is determined as below:

Weighted Average Flotation Cost = Equity Flotation Cost*(E/V) + Debt Flotation Cost*(D/V) where E = Equity, D = Debt and V = Total Value or (D + E)

Substituting values in the above formula, we get,

5.04% = 7.4%*(E/V) + 3.4%*(D/V)

Rearranging Values, we get

5.04%*(V) = 7.4%*E + 3.4%*D

5.04%*(D + E) = 7.4%*E + 3.4%*D

5.04%*D + 5.04%*E = 7.4%*E + 3.4%*D

5.04%*D - 3.4%*D = 7.4%*E - 5.04%*E

D/E = (7.4% - 5.04%)/(5.04% - 3.4%) = 1.44 (answer)