Question

Fama’s Llamas has a WACC of 9.1%. The company’s cost of equity is 11% and its cost of debt is 6.4%. The tax rate is 21%.

What is the company’s debt-equity ratio?

Answer 1

Let weight of debt = X

So, Weight of equity = 1 – X

Cost of equity = 11%

Cost of debt = Interest rate x (1 - Tax Rate)

= 6.4% x (1 – 0.21)

= 5.06%

Weighted average cost of capital

= Weight of equity x Cost of equity + Weight of debt x Cost of debt

So, 9.1 = (1 – X) x 11 + X x 5.06

So, 9.1 = 11 – 11X + 5.06 X

So, 5.94 X = 11 – 9.1

So, X = 1.9 / 5.94

= 0.32

So, weight of debt = 0.32 or 32%

Weight of equity = 1 – Weight of debt

= 1 – 0.32

= 0.68 or 68%

So, Debt-Equity Ratio

= Weight of Debt / Weight of equity

= 32 / 68

= 1 : 2.13