Fama’s Llamas has a weighted average cost of capital of 10.7 percent. The compan

Question

Fama’s Llamas has a weighted average cost of capital of 10.7 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 8.7 percent. The tax rate is 40 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 10.7 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 8.7 percent. The tax rate is 40 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

After tax cost of debt=8.7(1-0.4)=5.22%

Let debt be $x

Equity be $y

Total=$(x+y)

WACC=Respective costs*Respective investment weights

0.107=(x/(x+y))*0.0522)+(y/(x+y)*0.12)

0.107(x+y)=0.0522x+0.12y

0.107x+0.107y=0.0522x+0.12y

x=(0.12-0.107)y/(0.107-0.0522)

=0.237226277y

Hence debt-equity ratio=Debt/Equity

=x/y

=0.2372(Approx)

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