Can someone please make sense of this for me. Sometimes (according to Schweser) it’s ok to use Debt/Equity to calculate wacc but other times you have to use the DR / (1+DR). The use of it seems completely illogical (even in the Mock today one problem used D/E and then another you were supposed to use the DR/(1+DR). Does anyone understand when you’re supposed to use them?
So long as you get the right answer , what does it matter? DR=D/(D+E) . So work it out.
It should be D/(1-D) Debt = $1 million, Equity=$2 million. What’s your D/E ratio? (1/3)/(2/3), or 33/67 (note that 33+67 =100). What’s your D/(1-D)? It is (1/3)/(1-(1/3)) = 33/67. Debt = $1 million, Equity=$3 million. What’s your D/E ratio? (1/4)/(3/4), or 25/75 (note that 25+75=100). What’s your D/(1-D)? It is (1/4)/(1-(1/4)) = 25/75.
janaksri - It’s not the same. A DR = .30 is not the same as using .3 /(1.3) = .23
Thanks for getting me straight on this.
Dreary, what about this situation: Target Debt to Equity Ratio = 0.30 Re = 18% Kd = 10% Tax Rate = 30% What’s the wacc?
WACC = 0.30 ((0.10)(0.7) + 0.70 (0.18) = 14.7%
And here’s the whammy… that is straight from Schweser and here’s the correct answer: Debt to capital ----- 23.08% ----- Debt-to-equity divided by one plus debt-to-equity: 0.30 / (1 + 0.30). After-tax cost of debt ----- 7.00% ----- Cost of debt times one minus tax rate: 10% × (1 − 0.30). WACC ------ 15.46% ----- Cost of equity and debt weighted by targeted weights: (18% × (1 − 0.2308)) + (7% × 0.2308).
This is weird…and that’s why I never use Schweser. Debt to Equity Ratio = 0.30 means take your debt divide by equity and you get 0.30. That can only happen if equity is 3 times and 1/3 of debt, i.e., equity = 3.333 x (0.30)= 1.00, and debt =0.30, for any amounts of debt and equity. In some context, it may be possible to argue that D+E does not equal assets (A), say you are taking debt as long-term debt only…in that case, may be Schweser has a point.
Yeah, there’s just no reason why that’s used (and Schweser does it in other places too). Would love to know if someone can come up with an explanation
Debt to Equity Ratio = 0.30, so Debt/Equity=0.3 and Debt+Equity = 1.0 So Debt = 1-Equity or 1/Equity -1 =0.3 or Equity = 1/1.3 = 0.76923 and debt = 0.23077. So Dreary is incorrect in saying : “WACC = 0.30 ((0.10)(0.7) + 0.70 (0.18) = 14.7%” It should be 0.77*18+0.23*10*0.7 = 15.475
Good point janakisri - need to make sure I break down the D/E ratios like that when given from now on. Thanks.
oh man… you’re right, although I have not seen it in CFAI texts as that. They usually say D/E = 30/70, etc.
easiest way is debt to equity =0.3 Result is D/E = 3/10 Weight are always (D/(D+E)) and (E/(D+E)) Debt weight 3/13 Equity Weight 10/13
> D/E = 3/10 > Debt weight 3/13 > Equity Weight 10/13 That’s easier to remember! Thanks.
I look at it as if D/E= 0.3, then D:E =1:0.3, then debt =(1/1.3) and equity=0.3/1.3
jeff, D/E = 0.3 means D:E = 0.3 : 1 D/(D+E) = 0.3/(1+0.3)=0.3/1.3 E/(D+E) = 1/1.3
Guys, check this out. Just treat like an algebra equation from highschool. For instance, if E/D = 0.3, well you also know that E + D = 1.0. So, just solve for E…or D for that matter.