Question

Fama's Llamas has a weighted average cost of capital of 9 percent. The company's cost of equity is 16 percent, and its pretax cost of debt is 10 percent. The tax rate is 36 percent. What is the company's target debt-equity ratio?

Answer 1

Solution :

WACC = 9%, Cost of equity = 16% , Pre tax cost of debt = 10% , tax rate = 36%

So after tax cost of debt = Pre tax cost of debt * (1-tax) = 10% * (1-0.36) = 6.4%

Let's assume Debt weightage [Debt / (debt+ equity)] is X

then equity weightage [ equity / (Debt + Equity ) ]will be 1-X

From the WACC formula we know that

WACC = Cost of equity * Equity weightage + Cost of debt * Debt weightage

Putting the values of known parameters

0.09 = 0.16 * ( 1 - X) + 0.064 * X

0.09 = 0.16 - 0.16X +0.064X

0.096X = 0.16-0.09 = 0.07

X = 0.7292

Means debt weightage = 0.7292

Equity weightage = 1X = 1- 0.7292 = 0.2708

Target Debt to equity = 0.7292 /  0.2708 = 2.6923