Final answer:
The debt-equity ratio is deduced using the WACC, cost of equity, after-tax cost of debt, and the tax rate. By rearranging the WACC formula and substituting in the given values, we can solve for the debt-equity ratio of Kountry Kitchen.
Step-by-step explanation:
The question involves solving for the debt-equity ratio of Kountry Kitchen, given its cost of equity, pretax cost of debt, tax rate, and weighted average cost of capital (WACC). The WACC is a blend of the cost of equity and after-tax cost of debt, weighted by the proportion of equity and debt in the company's capital structure.
To find the debt-equity ratio, we use the WACC formula:
WACC = E/V x Re + D/V x Rd x (1 - Tc)
Where:
E = Market value of equity
D = Market value of debt
Re = Cost of equity (12.2 percent)
Rd = Pretax cost of debt (6.1 percent)
Tc = Corporate tax rate (21 percent)
V = E + D
Since WACC is given as 9.07 percent and we have Re, Rd, and Tc, we need to find the values of E and D, which would help us calculate the debt-equity ratio (D/E). After substituting all known values, we can solve for E/V and D/V, leading to the calculation of the debt-equity ratio.
To reiterate, the cost of equity is important in calculating the WACC as it represents the returns required by equity investors based on the risk of the investment. Solving for the debt-equity ratio will thus take into account the cost of equity in relation to the proportion of debt financing, after accounting for the tax savings due to interest expense.