Question

Fama’s Llamas has a weighted average cost of capital of 10.9 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 8.9 percent. The tax rate is 38 percent. What is the company’s target debt−equity ratio?

Answer 1

0.2

Step-by-step explanation:

The weighted average cost of capital (WACC) is calculated as below:

WACC = (D/A) x r_D x (1-t) + (E/A) x r_E , where:

A: Market value of company asset;

D: Market value of company debt;

E: Market value of company equity;

r_D: pre-tax cost of debt;

r_E: cost of equity;

t: tax rate

Rearrange above formula a bit, we get:

WACC = (D/A) x r_D x (1-t) + (1 - D/A) x r_E

Putting all the numbers together, we have:

10.9% = (D/A) x 8.9% x (1 - 38%) + (1 - D/A) x 12%

Solve the equation, we get D/A = 17% or D/E = 0.2

So, target debt−equity ratio is 0.2