Fama’s Llamas has a weighted average cost of capital of 10.9 percent. The compan

Question

Fama’s Llamas has a weighted average cost of capital of 10.9 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 8.9 percent. The tax rate is 38 percent. What is the company’s target debtequity ratio? (Do not round intermediate calculations and round your final answer to 4 decimal places, e.g., 32.1616.)

Fama’s Llamas has a weighted average cost of capital of 10.9 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 8.9 percent. The tax rate is 38 percent. What is the company’s target debtequity ratio? (Do not round intermediate calculations and round your final answer to 4 decimal places, e.g., 32.1616.)

Explanation / Answer

Ko = [(Kd after tax * Wd) + (Ke*We)] / (Wd+We)
here,

Ko (overall cost of capital) = 10.9 %
Kd (cost of debt) after tax = Kd before tax (1-tax rate)
                    = 8.9 (1-0.38)
                    = 5.518%
Ke(cost of equity) = 12%
Wd + We always remains = 1
Accordingly, We can be = 1 - Wd

Ko = [(Kd after tax * Wd) + (Ke*We)] / (Wd+We)
10.9 = [5.518 Wd + 12 (1- Wd)] / 1
10.9 = 5.518 Wd +12 - 12 Wd
10.9- 12 = 5.518 Wd -12 Wd
-1.1 = -6.482 Wd
6.482 Wd= 1.1
Wd = 1.1 / 6.482
      = 0.1697
We = 1- Wd
     = 1 - 0.1697
     = 0.8303

Debt/equity ratio = Wd/We
                         = 0.1697/0.8303
                          = 0.2044 times

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