In an example for a project beta… the given D/E ratio is 2. So D = 2 and E = 1.
It says in order to find the actual weights of the Debt and Equity you need to:
D = D/ (D+E) —> 2/(2+1) = 2/3
E = E/ (D+E) —> 1/(2+1) = 1/3
Why do you use D/(D+E) to figure out the weight of debt. I do not get it Intuitivley why you would use this equation… or is it just the fact that i may need to brush up on simple algebra??
D/(D+E) means the proportion of debt out all the funding methods which consist of equity and debt. this proportion is called weights. How is this not intuitive?
In a much more boring explanation:
If you have a basket of apples and pears the proportion of pears is P/ P+A (because P+A is the total amount in the basket) The proportion of pears is the “weight” of pears.
So instead there is a basket of debt and equity. now does the proportion of debt = D/D+E make sense?
D/E Ratio of 5 means for every 1 unit (unit here is money to be more simple) of Equity you have 5 units of Debt. So when we look at it this way a D/E ratio of 5 applied in the given formula gives us:
D = 5/(5+1) = 5/6
E = 1/(5+1) = 1/6
We could go further and find out the capital structure in percentage by multiplying 100% to both of the above. We would get:
D = 83.33 %
E = 16.67 %
Thanks guys. The simple exam of apples and pears really works! Sometimes I think i get too caught up in the formuals and need to take a step back and think about what they mean first. Appreciate the help.