Question

Fama's Llamas has a weighted average cost of capital of 7.9 percent. The company's cost of equity is 11 percent, and its cost of debt is 5.8 percent. The tax rate is 25 percent. What is Fama's debt-quity ratio?

Answer 1

- Fama's Llamas has a Weighted average cost of capital(WACC) = 7.9 percent

Let us take weight of debt as X

& weight of Equity as (1-X)

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

7.9% = (X)(5.8%)(1-0.25) + (1-X)(11%)

7.9% = X*4.35% + 11% - X*11%

7.9% -11% =-X*6.65%

3.1% = X*6.65%

X = 0.4662

So, weight of Debt is 0.4662

Weight of Equity = (1 - 0.4662) = 0.5338

So, Fama's debt-quity ratio = Debt/Equity = 0.4662/0.5338

Fama's debt-quity ratio = 0.8734

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