Fama’s Llamas has a weighted average cost of capital of 12.5 percent. The company’s cost of equity is 15.5 percent, and its pretax cost of debt is 7.5 percent. The tax rate is 33 percent. What is the company’s target debt-equity ratio

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2.98K viewsOctober 22, 2016

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Darshita 6.14K October 22, 2016 0 Comments

Fama’s Llamas has a weighted average cost of capital of 12.5 percent. The company’s cost of equity is 15.5 percent, and its pretax cost of debt is 7.5 percent. The tax rate is 33 percent.

What is the company’s target debt-equity ratio? (Do not round your intermediate calculations.)

1 Answer

score 0 · Answer 1 · 2016-10-22T09:23:09+00:00

Answer : company’s target debt-equity ratio= 0.38

Working Notes for the above answer is as under

let x = weight of debt, so (1 – x) = weight of equity

Using WACC…
0.125 = 0.155(1 – x) + x* (0.77 * (1 – 0.33))
0.125 = 0.155 – 0.155x + 0.0469x
0.03 = 0.1081x
x = 0.2775<weight of debt…i.e. Debt/Total Capital…D/C
(1 – x) = 0.7225<weight of equity
D/E = weight debt / weight equity = 0.2775 / 0.7225 = 0.38

1 Answer

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