Question

smart carvings wants to have a weighted average cost of capital of 10 percent. the firm has an aftertax cost of debt of 6.5 percent and a cost of equity of 12.75 percent. what debt-equity ratio is needed for the firm to achieve its targeted weighted average cost of capital? a) .786 b) .920 c) 1.08 d) .765 e) .675

Answer 1

To reach its desired weighted average cost of capital, the company must have a favorable debt-to-equity ratio as under.  

Capital  56%                                                                                                                         Debt   44%  

$WACC= kе (E/E+D) + Kd (1-t) (D/E+D)$                                              Ke 12.75%

Kd(1-t) = (debt after-tax) (debt after-tax) 6.5%

WACC desired = 10%

What capital infrastructure enables the WACC?

We are aware of:

Equity weight plus debt weight equals one.

Weight of equity = 1 minus Weight of Debt

We can determine the weight of equity.

.10= 0.1275(We)+0.065(1-We)

.10=0.1275(We)+03065 X 1-0.065 X We

.10-0.065 = 0.1275(We) - 0.065 X We

0.035 = 0.0625 We

We= 0.035/ 0.0625  = 0.56

equity weight = 0.56 =56%

Weight of equity = 1 - 0.56 = 44% ; weight of debt = 1.

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