Question

• If a firm has an ROE of 12 percent, a financial cost effect of 9.5 percent, and an pre-tax ROIC of 10 percent, what is its debt-to-equity ratio (total debt divided by owners’ equity)? Assume that the firm does not pay any tax.

Answer 1

Assume Debt % to Total Value is D with cost fo debt rd = 9.5%

Equity % to Total Value (E) = 1-D; Cost of Equity = re = 12%

ROIC = WACC = 10%

Tax = 0% ( ignore tax)

ROIC = Debt % x Cost of Debt x ( 1- tax) + Equity % x Cost of equity

10% = D x 9.5% + (1-D) x 12 %

Solving for D, we get D = 80% ; Equity = 1- D = 1-80% = 20%

Debt: Equity Ratio = D/E = 80%/20% = 4

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