Question

Fama’s Llamas has a weighted average cost of capital of 9.1 percent. The company’s cost of equity is 14 percent, and its pretax cost of debt is 6.4 percent. The tax rate is 24 percent. What is the company’s target debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

Answer 1

Let's assume weight of Debt to be X

& weight of equity be(1-X)

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

9.10% = (X)(6.40%)(1-0.24) + (1-X)(14%)

9.10% = X*4.864% + 14% - X*14%

4.90% = X*9.136%

X = 53.63%

So, weight of Debt = 53.63%

Weight of Equity = 46.37%

Company's target debt-equity ratio = Debt/Equity

= 53.63%/46.37%

= 1.1566

So, target debt-equity is 1.1566

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