Question

Target Capital structure

Fama's Lama has a weighted average cost of capita of 10%. The company's cost of equity is 12%, pre tax cost of debt is 8%. If the tax rate is 0% then what is the target debt to equtiy ratio?

Answer 1

Answer:

Weighted Average Cost of Capital = 10%
Weighted Average Cost of Capital = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
Let the Weight of Debt be “x”
Weight of Equity will be “1 – x”

Weighted Average Cost of Capital = (x * 0.12) + [(1 – x) * 0.08]
0.10 = 0.12x + [0.08 – 0.08x]
0.10 = 0.12x + 0.08 – 0.08x
0.02 = 0.04x
x = 0.50

Weight of Debt = 0.50
Weight of Equity = 1 – 0.50 = 0.50

Target Debt to Equity Ratio = Debt / Equity
Target Debt to Equity Ratio = 0.50 / 0.50
Target Debt to Equity Ratio = 1