Question

Check my work Fama's Llamas has a weighted average cost of capital of 10.5 percent. The company's cost of equity is 17 percent, and its pretax cost of debt is 8 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio? points eBook Multiple Choice Print 0 References 0 0 0 0

Fama's Llamas has a weighted average cost of capital of 10.5 percent. The company's cost of equity is 17 percent, and its pretax cost of debt is 8 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio?

Answer 1

Answer: 1.2452

WACC=10.5%
Cost of equity=17%
Pretax cost of debt=8%
Tax rate=34%

WACC=(Weight of equity)*(Cost of equity)+(Weight of debt)*(Pretax cost of debt)*(1-Tax rate)

10.5=(Weight of equity)*(17)+(Weight of debt)*(8)*(1-34%)
10.5=(Weight of equity)*(17)+(Weight of debt)*5.28

Weight of equity=Equity/(Debt+Equity)
Weight of debt=Debt/(Debt+Equity)
Substituting the equation for weights, we get

10.5=(Equity/(Debt+Equity))*(17)+(Debt/(Debt+Equity))*5.28
10.5*(Debt+Equity)=Equity*17+Debt*5.28
10.5*Debt+10.5*Equity=Equity*17+Debt*5.28
10.5*Debt-Debt*5.28 =Equity*17-10.5*Equity

Debt*(10.5-5.28)=Equity*(17-10.5)
Debt/Equity=(17-10.5)/(10.5-5.28)
=6.5/5.22
=1.2452

Hence, the debt to equity ratio is 1.2452