Question

Kountry Kitchen has a cost of equity of 10.6 percent, a pretax cost of debt of 5.2 percent, and the tax rate is 39 percent. If the company's
WACC is 8.59 percent, what is its debt-equity ratio?


Multiple Choice


Ο 1.34


Ο 2.70


Ο .50


Ο .27


Ο .37

Answer 1

Answer: .27

Explanation:

The Debt to Equity Ratio is the amount of Debt per dollar that the company owes per dollar of Equity. It must add up to 1.

The Weighted Average Cost of Capital measures just how much a company needs to pay to it's capital holders including shareholders and debt holders.

The formula is,

WACC = (Cost of equity * Weight of equity) + (Cost of debt * Weight of debt)

Remember that Debt is tax deductible so the After tax cost of debt should be,

= 5.2% ( 1 - tax rate)

= 5.2% * ( 1 - 39%)

= 3.172%.

The debt weight is the amount of debt that the company has per dollar so that means that it is also the Debt to Equity ratio. Denote it as 'x' to find it. Remember that they must add up to one.

WACC = (Cost of equity * Weight of equity) + (Cost of debt * Weight of debt)

8.59% = 10.6% ( 1 - x) + 3.172%( x)

8.59% = 10.6% - 10.6%x + 3.172%x

8.59% = 10.6% - 7.428%x

7.428%x = 10.6% - 8.59%

7.428%x = 2.01%

x = 0.271

= 27%

Debt to Equity is 0.27.