Question

A firm wants to create a weighted average cost of capital (WACC) of 12 percent. The firm's cost of equity is 16 percent and its pre-tax cost of debt is 6 percent. The tax rate is 20 percent. What does the debt-equity ratio (D/E) need to be for the firm to achieve its target WACC

Answer 1

Answer: 0.56

Step-by-step explanation:

After tax cost of debt is:

= 6% * ( 1 - 20%)

= 4.8%

Assume that the weight for debt is "x" which would mean that the weight for Equity is "1 - x".

WACC = (Weight of equity * cost of equity) + (Weight of debt * After tax cost of debt)

0.12 = ( (1 - x) * 0.16) + 0.048x

0.12 = 0.16 - 0.16x + 0.048x

0.12 - 0.16 = - 0.112x

x = -0.04 / -0.112

x = 35.7%

Weight of equity = 1 - 35.7% = 64.3%

Debt to equity ratio:

= 35.7% / 64.3%

= 0.56