Question

Salem Mills has an unlevered cost of capital of 14 percent, a cost of debt of 9 percent, and a tax rate of 34 percent. What is the target debt-equity ratio if the targeted cost of equity is 16.5 percent?

Answer 1

SOLUTION:

The values of Salem Mills provided in the question are as follows:

Unlevered cost of capital i.e. unlevered cost of equity =14 percent

Cost of debt = 9 percent

Tax rate = 34 percent. Or 0.34

Target debt-equity ratio=?

Targeted cost of equity i.e. levered cost of equity = 16.5 percent

As per Modigliani-Miller Theorem with taxes, a firm's levered cost of equity is related to the unlevered cost of equity is as follows:

Levered cost of equity = unlevered cost of equity + debt-equity ratio * (unlevered cost of equity - cost of debt)*(1 - tax rate)

Using the values provided in the question,

16.5 =14+ debt-equity ratio *(14-9)*(1-0.34)

16.5-14 = debt-equity ratio *5*0.66

2.5= debt-equity ratio *3.3

Debt-equity ratio =2.5/3.30

Debt-equity ratio =0.7576