Clifford, Inc., has a target debt–equity ratio of .86. Its WACC is 8.5 percent,

Question

Clifford, Inc., has a target debt–equity ratio of .86. Its WACC is 8.5 percent, and the tax rate is 34 percent. a. If the company’s cost of equity is 12.6 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 5.2 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 %

Explanation / Answer

a) Given,

Formuale:

weighted cost of debt + weighted cost of equity = weighted average cost of capital

let cost of debt be 'x'

hence . (Kd after tax) (weight) + (Ke)*weight) = WACC

(x-34%)(0.86)+(12.6)(0.14) = 8.5

0.5676x +1.764 = 8.5

x = 11.86

Therefore from the above claculations , pretax cost of debt is determined as 11.86%

b) Given post tax cost of debt - 5.2% then the pre tax cost of debt would be as below

5.2% - 66% i.e 100-34 =66

thus for 100% it is 7.8%, therefore the pre tax cost of debt is7.8%

(7.8-34%)(0.86)+(x)(0.14) = 8.55

4.42+0.14x=8.55

x=29.5%

Therefore cost of equity is 29.5%

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