Question

Fama's Llamas has a weighted average cost of capital of 12.5 percent. The company's cost of equity is 17 percent, and its pretax cost of debt is 7 percent. The tax rate is 34 percent. What is the company's target debt-equity ratio?

Stock in Country Road Industries has a beta of 0.91. The market risk premium is 7.5 percent, and T-bills are currently yielding 5 percent. The company's most recent dividend was $1.7 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely. If the stock sells for $37 per share, what is your best estimate of the company's cost of equity

Answer 1

1) Debt-Equity Ratio is 0.57

Step-1:Calculation of weight of debt and Equity
Weighted Average cost of capital	=	(Wd*Kd)+(We*Ke)
0.1250	=	(x*0.0462)+((1-x)*0.17)
0.1250	=	(0.0462x)+(0.17-0.17x)
0.1250	=	-0.1238x+0.17
-0.0450	=	-0.1238x
0.1238x	=	0.0450
x	=	0.3635
1-x	=	0.6365
Working:
Assumed weight of Debt is "x" and Equity is "1-x".
After tax cost of debt	=	Before tax cost of debt * (1-Tax Rate)
	=	7%*(1-0.34)
	=	0.0462
Step-2:Calculation of debt-Equity Ratio
Debt-Equity Ratio	=	Weight of debt	/	Weight of Equity
	=	0.3635	/	0.6365
	=	0.57