Fama\'s Llamas has a weighted average cost of capital of 9.8 percent. The compan

Question

Fama's Llamas has a weighted average cost of capital of 9.8 percent. The company's cost of equity is 12 percent, and its pretax cost of debt is 7.8 percent. The tax rate is 40 percent. What is the company's target debt-equity ratio? Please show steps. Fama's Llamas has a weighted average cost of capital of 9.8 percent. The company's cost of equity is 12 percent, and its pretax cost of debt is 7.8 percent. The tax rate is 40 percent. What is the company's target debt-equity ratio? Please show steps.

Explanation / Answer

WACC = weight of debt* Cost of Debt (1 - tax rate) + weight of equity * cost of equity

9.8% = weight of debt * 7.8%(1-0.4) + weight of equity * 12%

Let weight of debt be x ; so weight of equity = 1 - x

9.8% = x * 4.68% + (1 - x) * 12%

9.8 = 4.68 x + 12 - 12x

7.32 x = 2.2

x = 30% so 1 -x = 70%

Target Debt to equity ratio = 30 : 70

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