Question

Fama’s Llamas has a weighted average cost of capital of 9.3 percent. The company’s cost of equity is 12.9 percent, and its cost of debt is 7.5 percent. The tax rate is 23 percent. What is the company’s debt-equity ratio? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

Answer 1

After-tax Cost of Debt = Before Cost of debt * (1 - Tax Rate)
After-tax Cost of Debt = 7.500% * (1 - 0.23)
After-tax Cost of Debt = 5.775%

Let Weight of Debt be x and Weight of Equity be (1 - x)

WACC = Weight of Debt * After-tax Cost of Debt + Weight of Equity * Cost of Equity
0.0930 = x * 0.05775 + (1 - x) * 0.1290
0.0930 = x * 0.05775 + 0.1290 - x * 0.1290
x * 0.07125 = 0.0360
x = 0.50526

Weight of Debt = 0.50526

Weight of Equity = 1 - x
Weight of Equity = 1 - 0.50526
Weight of Equity = 0.49474

Debt-Equity Ratio =Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.50526 / 0.49474
Debt-Equity Ratio = 1.0213