Question

Clifford, Inc., has a target debt-equity ratio of 1.20. Its WACC is 8.7 percent, and the tax rate is 25 percent. a. If the company’s cost of equity is 13 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.) b. If instead you know that the aftertax cost of debt is 5.8 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.)

Answer 1

Answer : a.) Calculation of Pretax cost of Debt

WACC = [Cost of Equity * Weight of Equity] + [Cost of Debt pre tax * (1-tax rate) * Weight of Debt]

Weight of Debt = 1.20 / 2.20 = 0.5455

Weight of Equity = 1 - 0.5455 = 0.4545

Cost of Equity = 13%

WACC = [Cost of Equity * Weight of Equity] + [Cost of Debt pre tax * (1-tax rate) * Weight of Debt]

8.70% = [13% * 0.4545] + [ Cost of Debt pre tax * (1-0.25) * 0.5455]

8.70% = 5.9085 % + [Cost of Debt pre tax * 0.75 *0.5455]

2.7915% = 0.409125 * Cost of Debt pre tax

==> Cost of Debt Before tax= 2.7915% / 0.409125

= 6.82%

(b.) Calculation of Cost of Equity given after tax cost of debt is 5.8%

WACC = [Cost of Equity * Weight of Equity] + [Cost of Debt after tax * Weight of Debt]

8.70% = [ Cost of Equity * 0.4545] + [5.8% *0.5455]

8.70% = [0.4545 * Cost of Equity] + [3.1639%]

8.70% - 3.1639% = 0.4545* Cost of Equity

==> Cost of Equity = 5.5361% / 0.4545

= 12.18%