Question

Macfarlane, Inc., recently issued new securities to finance a new TV show. The project cost $13.5 million and the company paid $675,000 in flotation costs. In addition, the equity issued had a flotation cost of 6.5 percent of the amount raised, whereas the debt issued had a flotation cost of 2.5 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

The total cost of the equipment including floatation costs was:

Total costs = $13,500,000 + $675,000 = $14,175,000

Using the equation to calculate the total cost including floatation costs, we get:

Amount raised(1 – f_T) = Amount needed after floatation costs

$14,175,000(1 – f_T) = $13,500,000

f_T = 0.0476 or 4.76%

Now, we know the weighted average floatation cost. The equation to calculate the percentage floatation costs is:

f_T = 0.0476 = 0.065(E/V) + 0.025(D/V)

We can solve this equation to find the debt-equity ratio as follows:

0.0476(V/E) = 0.065 + 0.025(D/E)

We must recognize that the V/E term is the equity multiplier, which is (1 + D/E), so:

0.0476(D/E + 1) = 0.065 + 0.025(D/E)

D/E = 0.7684