Debt/Equity vs. Debt/Capital?? problem, another, completely, understand

fishmarket

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?

OmarAdnan

So long as you get the right answer , what does it matter?

DR=D/(D+E) . So work it out.

onelife1

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.

tikfed

Thanks for getting me straight on this.

bingbingliang

Dreary, what about this situation:

Target Debt to Equity Ratio = 0.30
Re = 18%
Kd = 10%
Tax Rate = 30%

What's the wacc?

tarunajwani

WACC = 0.30 ((0.10)(0.7) + 0.70 (0.18) = 14.7%

RepoToronto

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%

bdavi77962

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.

tianxin

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

hassan

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



Edited 2 time(s). Last edit at Saturday, May 22, 2010 at 08:19PM by janakisri.