Question

Fama’s Llamas has a weighted average cost of capital of 9.9 percent. The company’s cost of equity is 13.5 percent, and its cost of debt is 8.1 percent. The tax rate is 24 percent. What is the company’s debt-equity ratio?

Answer 1

Here, we’ve, Weighted Average Cost of Capital = 9.90%

Before-Tax Cost of Debt = 8.10%

Cost of Equity = 13.50%

Tax Rate = 24%

Let’s Take “W” as the weight of Debt

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

0.0990 = [0.0810(1 – 0.24) x W] [0.1350 x (1 – W)]

0.0990 = [0.0616 x W] + [0.1350 – 0.1350W]

0.0990 = 0.0616W + 0.1350 – 0.1350W

0.1350 – 0.0990 = 0.1350W – 0.0616W

0.0360 = 0.0734W

W = 0.0360 / 0.0734W

W = 0.4902

Therefore, the Weight of Debt = 0.4902

Weight of Equity = 0.5098 [ie, 1 – 0.4902]

Therefore, the company’s debt-equity ratio = Weight of Debt / Weight of Equity

= 0.4902 / 0.5098

= 0.9615

“Hence, the company’s debt-equity ratio will be 0.9615”