Question

Candy Land Corp. has a WACC of 12.17%. The company’s equity beta is 1.3, and its semi-annual coupon bonds have a yield-to-maturity of 8.8% (APR, semi-annually compounded). The risk-free rate is 4%, the expected return on the market portfolio is 11.5%, and the tax rate is 35%. What is Candy Land’s debt-to-equity (D/E) ratio?

Answer 1

Cost of equity = Rf+ [beta (Rm-Rf)]

4+ [1.3 (11.5-4)]

4 + [1.3 *7.5]

4 + 9.75

13.75%

After tax cost of debt =Yield (1-tax)

8.8 (1-.35)

5.72%

Let the weightof debt be "X" weight of equity = 1-X

WACC= [After tax cost of debt *Wd]+[cost of equity *We]

12.17 = [5.72*x] + [13.75 (1-x)]

12.17 = 5.72x + 13.75 -13.75x

12.17 = -8.03 x +13.75

8.03x = 13.75-12.17

x = 1.58./8.03

= .1968

weight of debt = .1968

weight of equity = 1-.1968= .8032

Debt to equity =debt /equity

.1968 / .8032

= .2450 [rounded to .25]