Question

Fama’s Llamas has a WACC of 9.7 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 7.5 percent. The tax rate is 35 percent.
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

Answer:

0.4766

Explanation:

Given:

WACC = 9.7%

Company’s cost of equity = 12%

Pretax cost of debt = 7.5%

Tax rate = 35%

Now,

WACC

=  Weight × Cost of equity + (1 - weight) × Pretax cost of debt × (1-tax rate)

or

0.097 = weight × 0.12 + ( 1 - weight ) × 0.075 × (1 - 0.35)

or

0.097 = 0.12 × weight + 0.04875 - 0.04875 × weight

or

0.04825 = 0.07125 × weight

or

weight = 0.6772

also,

weight = $\frac{\textup{Equity}}{\textup{Debt + Equity}}$

or

$\frac{\textup{1}}{\textup{weight}}$  = $\frac{\textup{Debt+equity}}{\textup{Equity}}$

or

$\frac{1}{0.6772}$ = $\frac{\textup{Debt}}{\textup{Equity}}$  + 1

or

1.4766 = $\frac{\textup{Debt}}{\textup{Equity}}$  + 1

or

$\frac{\textup{Debt}}{\textup{Equity}}$  = 0.4766