Question

Fama's Llamas has a weighted average cost of capital of 12 percent. The company's cost of equity is 17 percent, and its pretax cost of debt is 7 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio? 0.7252 0.6974 0.6625 0.7322

Answer 1

After-tax cost of debt=7*(1-tax rate)

=7*(1-0.31)=4.83%

Let debt be $x

Equity be $y

Total=$(x+y)

WACC=Respective costs*Respective weight

12=(x/(x+y)*4.83)+(y/(x+y)*17)

12*(x+y)=4.83x+17y

12x+12y=4.83x+17y

x=(17-12)y/(12-4.83)

=0.6974 y(Approx)

Hence debt-equity ratio=debt/equity

=0.6974(Approx).