[Anonymous]

In the Wiley 2012 book, it’s #129 in Module 44.

Question:

Hi-Tech, Inc. has determined that it can minimize its weighted-average cost of capital by using a debt/equity ratio of 2/3. If the firm’s cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm’s WACC?

Answer:

9.36% – They arrived at this using the following formula: [2/5 x {9%(1-40%)]} + (3/5 x 12%).

I don’t understand why you use 2/5 and 3/5 instead of 2/3 and 1/3.

[Anonymous]

It’s because a ratio of 2/3 means two parts debt + three parts equity = 5 parts total. So that’s where the 2/5 and 3/5 comes from. Hope that helps!

[kmwgrace]

Right, it's a ratio not a fraction. It should be 2:3 not 2/3.

~ Kate... MTX!
CPA exam on hold while I homeschool my 6 year old!

[Shay]

Thats how I understand it

Get your total weight of your investment…How much Debt and how much Equity then divide by total investment. So Debt=2 and Equity=3, and total investment is 5.

Your equation is Debt=2/5 and Equity is 3/5..This will give you the weight. Now multiply it by by interest (after-tax) for debt and cost of equity

Debt: (2/5 * .09 * .60 )==2.16

Equity: (3/5 * .12)==7.2==add them = 9.36

[Anonymous]

I think my brain is beyond fried at this point to comprehend something as simple as that. Makes total sense now thanks to you guys. I appreciate your replies 🙂

[Author]

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