Question

Chapter 13 Problems * Saved Fama's Llamas has a weighted average cost of capital of 9.8 percent. The company's cost of equity is 13.4 percent, and its cost of debt is 7.9 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.) 0.58 points Debt-equity ratio etlook Hint References < Prev 16 of 17 !! Next >

Answer 1

The formula for weighted average cost of capital (WACC) is:

WACC = w_e * r_e + w_d * r_d * (1 - t)

where,

r_e = Cost of equity = 13.4%

r_d = Cost of debt = 7.9%

w_e = Weight of equity (%) = x (assumed figure)

w_d = Weight of debt = 1 - x

t = tax rate = 23%

Now, putting these values in the WACC formula, we get,

9.8 = (x * 13.4) + (1 - x) * 7.9 * (1 - 0.23)

9.8 = 13.4x + (1 - x) * 7.9 * 0.77

9.8 = 13.4x + (1 - x) * 6.083

9.8 = 13.4x + 6.083 - 6.083x

9.8 - 6.083 = 13.4x - 6.083x

3.717 = 7.317x

x = 3.717 / 7.317 = 50.7995

So, weight of equity = 50.7995%

Weight of debt = (1- 0.507995) = 49.2004%

Now, debt equity ratio = Debt / Equity

Debt equity ratio = 50.7994 / 49.2004 = 1.0325