Fama\'s Llamas has a weighted average cost of capital of 12 percent. The company

Question

Fama's Llamas has a weighted average cost of capital of 12 percent. The company's cost of equity is 15 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio? (Do not round your intermediate calculations.)

rev: 09_20_2012

0.5086

0.5134

0.489

0.8571

0.4645

Fama's Llamas has a weighted average cost of capital of 12 percent. The company's cost of equity is 15 percent, and its pretax cost of debt is 8.5 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio? (Do not round your intermediate calculations.)

Explanation / Answer

Let the Debt be x and equity be y

Hence, Total = x+y

After Tax cost of Debt = Before Tax Cost of Debt * ( 1- Tax Rate)

= 8.50% * ( 1- 31%)

= 5.865%

WACC= Respective Cost * Respective Weights

12 % = x / ( x+y) * 5.865% + 15% * y /(x+y)

or 0.12 ( x+y) = 0.05865 x + 0.15 y

or 0.12 x + 0.12 y = 0.05865 x + 0.15 y

or 0.12 x - 0.05865 x = 0.15 y - 0.12 y

or 0.06135 x = 0.03 y

or x = 0.03 y / 0.06135

or x = 0.48899755501 y

or x / y = 0.489

Debt to Equity Ratio = Total Debt / Total Equity

0.489 = x/y

Hence the correct answer is 0.489

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