Question

Fama’s Llamas has a weighted average cost of capital of 10.5 percent. The company’s cost of equity is 13 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 35 percent. What is the company’s target debt−equity ratio? (Do not round intermediate calculations). Final Answer rounded to 4 decimal places.

Answer 1

The company’s target debt−equity ratio is :

Debt = 33 %

Equity = 67 %

Step-by-step explanation:

The Weighted Average Cost of Capital is the Cost of all permanent sources of finance pooled together.

WACC = ke × E/V + kd × D/E

Where,

ke = cost of equity

= 13%

E/V = Market Weight of Equity

= a

kd = cost of debt

= interest × ( 1 - tax rate)

= 8.5 % × (1 - 0.35)

= 5.525 %

D/E = Market Weight of Debt

= 1 - a

WACC = 13% × a + 5.525 % (1- a)

Solving this equation for a we get:

a = 0.67

Thus

Weight of Equity =0.67 or 67 %

Weight of Debt = 0.33 or 33 %