Question

Being Human, Inc., recently issued new securities to finance a new TV show. The project cost $14.6 million, and the company paid $785,000 in flotation costs. In addition, the equity issued had a flotation cost of 7.6 percent of the amount raised, whereas the debt issued had a flotation cost of 3.6 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., .1616.)

Answer 1

Answer: 1.6631

Explanation:

The company’s target debt-equity ratio will be calculated thus:

Let's assume x = equity

Let's assume (1-x) = debt

Total funds needed = $14,600,000 + $785,000 = $15,385,000

Then, we calculate the flotation which will be:

15,385,000 × (1 - f) = 14,600,000

15,385,000 - 15,385,000f = 14,600,000

-15,385,000f = 14,600,000 - 15385000

- 15,385,000f = -785,000

f = -785000 / -15385000

f = 0.05102

Then,

(7.6% × x) + (3.6% × 1-x) = 0.05102

(0.076 × x) + (0.036 × 1-x) = 0.05102

0.076x + 0.036 - 0.036x = 0.05102

0.076x - 0.036x = 0.05102 - 0.036

0.04x = 0.01502

x = 0.01502/0.04

x = 0.3755

Equity = 0.3755 = 3.755%

Debt = 1-x = 1 - 0.3755 = 0.6245

Debt equity ratio = Debt / Equity

= 0.6245/0.3755

= 1.6631

The debt-equity ratio is 1.6631.