Question

Clifford, Inc., has a target debt–equity ratio of .83. Its WACC is 8.7 percent, and the tax rate is 38 percent.

a. If the company’s cost of equity is 12.3 percent, what is its pretax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax cost of debt ______

b. If the aftertax cost of debt is 5.4 percent, what is the cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity % __________

Answer 1

Debt-equity ratio=Debt/equity

Hence debt=0.83 equity

Let equity be $x

Debt=$0.83x

Total=$1.83x

WACC=Respective costs*Respective weight

a.

8.7=(x/1.83x*12.3)+(0.83x/1.83x*Cost of debt)

8.7=6.721311475+(0.83/1.83*Cost of debt)

Cost of debt=(8.7-6.721311475)*(1.83/0.83)

=4.362650602%

Hence pre-tax Cost of debt=Cost of debt/(1-tax rate)

=4.362650602/(1-0.38)

=7.04%(Approx).

b.

8.7=(x/1.83x*Cost of equity)+(0.83x/1.83x*5.4)

8.7=(1/1.83*Cost of equity)+2.449180328

Cost of equity=(8.7-2.449180328)*1.83

=11.44%(Approx).