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 $13.2 million, and the company paid $645,000 in flotation costs. In addition, the equity issued had a flotation cost of 6.2 percent of the amount raised, whereas the debt issued had a flotation cost of 2.2 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.)

Debt-equity ratio

Explanation / Answer

THE TOTAL COST INCLUDING FLOTATION COSTS WAS:

TOTAL COSTS = $13200000 + $645000

= $13845000

USING THE EQUATION TO CALCULATE THE TOTAL COST INCLUDING FLOTATION COSTS, WE GET:

AMOUNT RAISED * (1 – FLOTATION RATE) = AMOUNT NEEDED AFTER FLOTATION COSTS

$13845000(1 – FLOTATION RATE) = $13200000

1 - FLOTATION RATE = $13200000 / $13845000

1 - FLOTATION RATE = 0.9534

FLOTATION RATE = 0.0466 OR 4.66%

NOW, WE KNOW THE WEIGHTED AVERAGE FLOTATION COST. THE EQUATION TO CALCULATE THE PERCENTAGE FLOTATION COSTS IS:

FLOTATION RATE = 0.0466 = 0.062(EQUITY /VALUE) + 0.022(DEBT / VALUE)

WE CAN SOLVE THIS EQUATION TO FIND THE DEBT-EQUITY RATIO AS FOLLOWS:

0.0466 (VALUE / EQUITY) = 0.062 + 0.022 (DEBT / EQUITY)

WE MUST RECOGNIZE THAT THE VALUE / EQUITY TERM IS THE EQUITY MULTIPLIER, WHICH IS

(1 + DEBT / EQUITY), SO:

0.0466 (DEBT / EQUITY + 1) = 0.062 + 0.022 (DEBT / EQUITY)

0.0466 DEBT / EQUITY + 0.0466 = 0.062 + 0.022 DEBT / EQUITY

0.0246 DEBT / EQUITY = 0.0154

DEBT / EQUITY = 0.6260

THE TOTAL COST INCLUDING FLOTATION COSTS WAS:

TOTAL COSTS = $13200000 + $645000

= $13845000

USING THE EQUATION TO CALCULATE THE TOTAL COST INCLUDING FLOTATION COSTS, WE GET:

AMOUNT RAISED * (1 – FLOTATION RATE) = AMOUNT NEEDED AFTER FLOTATION COSTS

$13845000(1 – FLOTATION RATE) = $13200000

1 - FLOTATION RATE = $13200000 / $13845000

1 - FLOTATION RATE = 0.9534

FLOTATION RATE = 0.0466 OR 4.66%

NOW, WE KNOW THE WEIGHTED AVERAGE FLOTATION COST. THE EQUATION TO CALCULATE THE PERCENTAGE FLOTATION COSTS IS:

FLOTATION RATE = 0.0466 = 0.062(EQUITY /VALUE) + 0.022(DEBT / VALUE)

WE CAN SOLVE THIS EQUATION TO FIND THE DEBT-EQUITY RATIO AS FOLLOWS:

0.0466 (VALUE / EQUITY) = 0.062 + 0.022 (DEBT / EQUITY)

WE MUST RECOGNIZE THAT THE VALUE / EQUITY TERM IS THE EQUITY MULTIPLIER, WHICH IS

(1 + DEBT / EQUITY), SO:

0.0466 (DEBT / EQUITY + 1) = 0.062 + 0.022 (DEBT / EQUITY)

0.0466 DEBT / EQUITY + 0.0466 = 0.062 + 0.022 DEBT / EQUITY

0.0246 DEBT / EQUITY = 0.0154

DEBT / EQUITY = 0.6260

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