Question

Goodbye, Inc., recently issued new securities to finance a new TV show. The project cost $13.8 million, and the company paid $705,000 in flotation costs. In addition, the equity issued had a flotation cost of 6.8 percent of the amount raised, whereas the debt issued had a flotation cost of 2.8 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? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

  

Debt–equity ratio

Answer 1

Debt-equity ratio = 0.9417 (Approx.)

Explanation;

First of all let’s calculate total funds needed;

Total funds needed = Total project costs + Flotation costs

Thus, total funds needed ($13800000 + $705000) = $14505000

As per equation;

$14505000 * (1 – f) = $13800000

(1 – f) = $13800000 / $14505000

(1 – f) = 0.951396

f = 1 – 0.951396

f = 0.04860

Now let’s assume equity = x

And debt = 1 – x

0.068x + 0.028 (1 – x) = 0.04860

0.068x + 0.028 – 0.028x = 0.04860

0.068x – 0.028x = 0.04860 – 0.028

0.04x = 0.0206

X = 0.0206 / 0.04

X = 0.515

1 – x = 1 – 0.515

1 – x = 0.485

So equity = 0.515

Debt = 0.485

Thus debt-equity ratio = (0.485 / 0.515)

Debt-equity ratio = 0.9417 (Approx.)