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

Weighted average cost of capital = 9.3 %
Cost of equity = 12.9 %
Cost of debt = 7.5 %
Tax rate = 23 %

Calculation of company’s debt-equity ratio

Step 1 : Calculate the Weights of Debt & Equity

Let Weight of Debt = W
Weight of Equity = 1 - W

WACC = Kd(1-t)*Wd + Ke*We
Where, WACC = Weighted average cost of capital
kd = Cost of debt
ke = Cost of equity
Wd= Weight of Debt
We = Weight of Equity
t = tax rate

0.093 = 0.075 (1 - 0.23)*W + 0.129 * (1 - W)
0.093 = 0.075 (0.77)*W + 0.129 - 0.129W
0.093 = 0.05775*W + 0.129 - 0.129W
0.129W - 0.05775W = 0.129 - 0.093
0.07125W = 0.036
W = 0.5053

Weight of Debt = 0.505263
Weight of Equity = 1 - 0.505263 = 0.494737

Step 2 : Calculation of Debt-Equity ratio
Debt-Equity ratio = Debt / Shareholders equity
Debt-Equity ratio = Weight of Debt / Weight of Equity

Debt-Equity ratio = 0.505263 / 0.494737
Debt-Equity ratio = 1.0212766 or 1.0213

Debt-Equity ratio = 1.0213