WACC – Debt-to-Equity

Practice Question

Intro to Finance
Weighted Average Cost of Capital (WACC)
Debt-to-Equity
Short Answer

What proportion of a firm is equity financed if the WACC is 14%, the before-tax cost of debt is 7%, the tax rate is 35% and the required return on equity is 18%?

Answer +
Final Answer: 0.703
Explanation +

Step 1: Define Variables

  • WACC = 0.14
  • Cost of debt (before tax) = 0.07
  • Tax rate = 0.35
  • Cost of equity = 0.18

Step 2: Compute After-Tax Cost of Debt

\[ K_d(1 - T) = 0.07 \times (1 - 0.35) = 0.0455 \]

Step 3: Substitute into the WACC formula

\[ 0.14 = x \cdot 0.18 + (1 - x) \cdot 0.0455 \] \[ 0.14 = 0.18x + 0.0455 - 0.0455x = 0.1345x + 0.0455 \]

Step 4: Solve for \( x \)

\[ 0.14 - 0.0455 = 0.1345x \] \[ 0.0945 = 0.1345x \] \[ x = \frac{0.0945}{0.1345} \approx 0.703 \]

Conclusion: Approximately 70.3% of the firm is equity financed.