Question

Central Systems, Inc. desires a weighted average cost of capital of 8 percent. The firm has an after-tax cost of debt of 6 percent and a cost of equity of 11 percent. What debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital?

rev: 09_04_2018_QC_CS-136177

1.60

1.40

1.67

1.50

1.33

Answer 1

Let weight of Debt be D

Now, Weight of Debt + Weight of Equity = 1

So, Weight of Equity = 1 - Weight of Debt

Now, Weighted average cost of capital

= Weight of Equity x Cost of Equity + Weight of Debt x Cost of Debt

So, 8 = (1 - Weight of Debt) x 11 + Weight of Debt x 6

So, 8 = 11 – 11 x Weight of Debt + 6 x Weight of Debt

So, 5 x Weight of Debt = 11 – 8

So, Weight of Debt = 3 / 5

= 0.60

So, Weight of equity

= 1 – 0.60

= 0.40

So, Debt equity ratio

= Weight of debt / Weight of equity

= 0.60 / 0.40

= 1.50

So, as per above calculations, option D is the correct option