Question

Famaâs Llamas has a weighted average cost of capital of 7.9 percent. The companyâs cost of equity is 11 percent, and its pretax cost of debt is 5.8 percent. The tax rate is 25 percent. What is the companyâs target debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

Answer 1

companyâs target debt-equity ratio = 0.87323

Step-by-step explanation:

Given data:

Weighted Average Cost of Capital = 7.90%

cost of equity is 11 percent

pretax cost of debt is 5.8 percent

tax rate is 25 percent.

After-tax cost of debt = 5.8% (1 - 25%) = 4.35%

Weighted Average Cost of Capital = Debt weight * After tax cost of debt + equity weight * cost of equity

let debt weight is x

equity weight = 1-x

plugging all value

7.9 = 4.35*x*+11(1-x)

solving for x

x = 0.46616

so, equity weight = 1- 0.46616 = 0.533835 {equity weight = 1-x}

debt to equity ratio =
`(0.466165)/(0.533835) = 0.87323`