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Roy's Welding has a cost of equity of 14.1 percent and a pretax cost of debt of 7.7 percent. The required return on the assets is 13.2 percent. What is the debt-equity ratio based on M&M II with no taxes?

Answer :

federicoceverino

Answer:

The debt-equity ratio is equal to 16.36%.

Explanation:

Based on M&M, the required return on the assets is the weight average cost of capital. This is calculated with the equation

[tex]\frac{D}{V} * Cost of Debt + \frac{E}{V}  * Cost of Equity[/tex]

where D/V and E/V are the weight of the equity and debt on the total value of company (is equal to E+D). And D/V + E/V is equal to 1. So, E/V = 1 - D/V. Reeplacing in the first formula

[tex]14.1 * (1 - D/V) + 7.7 * D/V = 13.2[/tex]

Then

[tex]14.1  -  14.1 * D/V + 7.7 * D/V = 13.2[/tex]

Then

[tex] -6.4 * D/V = 13.2 - 14.1[/tex]

Finally

[tex]D/V = 0.9 / 6.4 = 14.0625%[/tex]

So E/V = 1 - 14.0625% = 85.9375%

Debt-equity ratio is equal to E/V / D/V = 14.0625/85.9375 = 16.36%

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