Question

Question 7 (10 points) Blue Ribbon, Inc. wants to have a weighted average cost of capital of 10 %. The firm has a cost of debt of 4% and a cost of equity of 12 %. What debt-equity ratio is needed for the firm to achieve their targeted weighted average cost of capital? The firm face a tax rate of 40%. 0.50 0.26 O 0.33

Answer 1

Let Weight of Debt be Wd and weight of Equity is We.
Also,
Wd = (1-We)
Cost of Debt, Kd = 4%
Cost of Equity, Ke = 12%
Weighted average Cost of Capital , Kc = 10%
Tax rate , t = 40%
Kc = (We * Ke) + (Wd * Kd)(1-t)
10 = 12We + (1-We)2.40
10 = 12We + 2.40 - 2.40We
7.60 = 9.60 We
We = 7.60/9.60
We = 0.79
Therefore, Wd = 0.21
Therefore, debt equity ratio = 0.21/0.79
= 0.26

Therefore, second option is the correct answer.