Question

Fama’s Llamas has a weighted average cost of capital of 9.6 percent. The company’s cost of equity is 12 percent, and its pretax cost of debt is 7.6 percent. The tax rate is 35 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

Solution:
	Company's debt–equity ratio	0.5150
Working Notes:
	WACC = 9.6%
	The cost of debt is 7.6%,
	After tax cost of debt (Kd) = Cost of debt x (1- tax rate)
	= 7.6% x ( 1-0.35)
	=4.94%
	Cost of common equity (Ke)=12%
	Debt equity ratio = Y       means Debt = Y of Equity
	where , Value of Equity E= 1
	Value of Debt D= Y
	Total Value of Capital Structure = E + D = V =1+ Y
	WACC= Ke x E/V + Kd   x D/V
	WACC = 12% x (1/(1+Y)) + 4.94% x (Y/(1+Y))
	9.6% x (1+ Y) =12% + 4.94% Y
	9.6% + 9.6% Y = 12% + 4.94% Y
	4.66% Y =12% - 9.6%
	4.66% Y =2.4%
	Y = 2.4%/4.66%
	Y=0.51502145
	Y=0.5150
Notes:
	Lets Check that
	WACC= Ke x E/V + Kd   x D/V
	WACC = 12% x (1/(1+Y)) + 4.94% x (Y/(1+Y))
	WACC = 12% x (1/(1+0.5150)) + 4.94% x (0.5150/(1+0.5150))
	WACC = 0.096000066
	WACC = 9.60%
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