Question

Judson Inc. recently issued new securities to finance a new TV show. The project cost $13.0 million, and the company paid $625,000 in flotation costs. In addition, the equity issued had a flotation cost of 6.0% of the amount raised, whereas the debt issued had a flotation cost of 2.0% of the amount raised. If Judson 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. Round the final answer to 4 decimal places.)

Debt–Equity ratio ____

Answer 1

Total Cost = Project Cost + Flotation Cost = $13,000,000 + $625,000 = $13,625,000

Amount Raised = Amount Needed / [1 - flotation cost]

$13,625,000 = $13,000,000 / [1 - fC]

1 - fC = $13,000,000 / $13,625,000

1 - fC = 0.9541

fC = 1 - 0.9541 = 0.0459, or 4.59%

WAfC = [wD * fC(Debt)] + [wE * fC(Equity)]

0.0459 = [(D/V) * 0.02] + [(E/V) * 0.06]

Divide both sides by (V/E)

0.0459[V/E] = 0.02 * [D/E] + 0.06

0.0459[1 + (D/E)] = 0.02*[D/E] + 0.06

0.0459 + 0.0459*[D/E] = 0.02*[D/E] + 0.06

0.0459*[D/E] - 0.02*[D/E] = 0.06 - 0.0459

0.0259*[D/E] = 0.0141

D/E = 0.0141 / 0.0259 = 0.5461