Asked by sasis foods on May 09, 2024
Verified
The Spartan Co. has an unlevered cost of capital of 11%, a cost of debt of 8%, and a tax rate of 35%. What is the target debt-equity ratio if the targeted cost of equity is 12%?
A) .44
B) .49
C) .51
D) .56
E) .62
Unlevered Cost
The cost of an investment that does not include the impact of borrowing; essentially the expense borne without considering the effect of leverage.
Targeted Cost
The desired or estimated cost of a product or project, set in order to achieve competitiveness and profitability objectives.
Debt-Equity Ratio
An indicator showing the relative mix of equity and debt financing employed by a company for its assets.
- Analyze the consequences of diverse debt-equity proportions on a firm's financing expenses.
Verified Answer
SD
Serigne Dame GUEYEMay 10, 2024
Final Answer :
C
Explanation :
First, we need to find the weighted average cost of capital (WACC) at the target debt-equity ratio:
WACC = (1 - D/E) x Cost of Equity + (D/E) x Cost of Debt x (1 - tax rate)
Since we want to achieve a targeted cost of equity of 12%, we can plug in the given values and solve for D/E:
0.12 = (1 - D/E) x 0.11 + (D/E) x 0.08 x 0.65
0.12 = 0.11 - 0.03D/E + 0.052D/E
0.03D/E = 0.03
D/E = 0.03/0.03 + 0.052
D/E = 0.51
Therefore, the target debt-equity ratio is 0.51 or 51%. Answer choice C is the correct answer.
WACC = (1 - D/E) x Cost of Equity + (D/E) x Cost of Debt x (1 - tax rate)
Since we want to achieve a targeted cost of equity of 12%, we can plug in the given values and solve for D/E:
0.12 = (1 - D/E) x 0.11 + (D/E) x 0.08 x 0.65
0.12 = 0.11 - 0.03D/E + 0.052D/E
0.03D/E = 0.03
D/E = 0.03/0.03 + 0.052
D/E = 0.51
Therefore, the target debt-equity ratio is 0.51 or 51%. Answer choice C is the correct answer.
Learning Objectives
- Analyze the consequences of diverse debt-equity proportions on a firm's financing expenses.