ABC Company is considering a project in the pie making business. Its debt currently has a yield of 12%. ABC has a leverage ratio of 2.3 and a marginal tax rate of 30%. XYZ Inc., a publicly traded firm that operates only in the pie making business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3%; the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating ABC’s project is:
We’re told that the leverage ratio is 2.3, but the book says I have to derive the d/e ratio from that. How do I know that “leverage ratio” = assets to equity? Is that something that is assumed on the test?
If they have a leverage ratio 2.3, you can derive this as Total Assets / Total Equity = 2.3 TA = 2.3 TE = 1
We know that A = L + E, therefore, if TA = 2.3 and TE = 1 then Total Liabilities must = 1.3
2.3 = 1.3 + 1
So we can conclude that D/E = 1.3/1 which is equal to 1.3
I believe that’s how I’ve done it in the past – might want to wait for clarification on it however.
Leverage ratio is one component of ROE. It measures how much of your assets are leveraged through non-equity claims.
The above poster is correct, however he makes an unlikely assumption that all liabilities are debt, and that book values of all the balance sheet is at market value, bad example. But based on incomplete information, we assume it’s true.
Thank you. I understand how to derive the ratios, I just wasn’t sure if we can assume that “leverage ratio” = total assets/total equity - I’ve heard “leverage ratio” used for numerous similar, but different, ratios.