Fama\'s Llamas has a weighted average cost of capital of 11.5 percent. The compa

Question

Fama's Llamas has a weighted average cost of capital of 11.5 percent. The company's cost of equity is 17.5 percent, and its pretax cost of debt is 8 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio? (Do not round your intermediate calculations.)

1.0535

1.0435

0.9532

1.0033

1.7143

Fama's Llamas has a weighted average cost of capital of 11.5 percent. The company's cost of equity is 17.5 percent, and its pretax cost of debt is 8 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio? (Do not round your intermediate calculations.)

Explanation / Answer

D. 1.0033

We have the WACC and need to find the debt-equity ratio of the company. Setting up the WACC equation, we find:

WACC = 0.115 = 0.175(E/V) + 0.08(D/V)(1 - 0.31)

Rearranging the equation, we find:

0.115(V/E) = 0.175 + 0.08(0.69)(D/E)

Now we must realize that the V/E is just the equity multiplier, which is equal to:

V/E = 1 + D/E

0.115(D/E + 1) = 0.175 + 0.0552(D/E)

Now, we can solve for D/E as:

0.0598(D/E) = 0.06

D/E = 1.0033

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