Question

DIY, Inc. wants to have a weighted average cost of capital of 10%. The firm has an after-tax cost of debt of 4% and a cost of equity of 12%. What debt-equity ratio is needed for the firm to achieve their targeted weighted average cost of capital?

Answer 1

We can form 2 equations using the given data-

Let x be the weight of equity and y be the weight of debt

x + y = 1...equation 1

12x + 4y = 10...equation 2

Multiplying equation 1 by 4,

4x + 4y = 4....equation 3

Deducting equation 3 from equation 2,

8x = 6

X =6/8 = 0.75

Y = 1 - x = 1 - 0.75 = 0.25

Weight of debt = 0.25 and weight of equity = 0.75

debt/ equity ratio = 0.25/0.75 = 0.3333333

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