What is the proportion of debt financing for a firm that expects a 24% return on equity, a 16% return on assets, and a 12% return on debt? Ignore taxes.

Question

Quizplus · Accepted Answer

The proportion of debt financing can be calculated using the formula for weighted average cost of capital (WACC):

WACC = (proportion of debt x cost of debt) + (proportion of equity x cost of equity)

Rearranging this formula gives:

Proportion of debt = (WACC - cost of equity) / (cost of debt - cost of equity)

Plugging in the given values:

WACC = 16% (since this is the return on assets, which represents the overall rate of return the firm must earn on its investments)
Cost of equity = 24%
Cost of debt = 12%

Proportion of debt = (0.16 - 0.24) / (0.12 - 0.24) = 0.67 or 67%

So the closest answer choice is C) 66.7%.

What Is the Proportion of Debt Financing for a Firm