Question

Cost of Common Equity and WACC Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 40%. The current stock price is . The last dividend was , and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC?

Answer 1

Answer:

Cost of common equity=15.74%

WACC=11.91%

Explanation:

Complete Question:

Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 40%. The current stock price is P0=$22.00. The last dividend was D0=$2.25, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC?

Answer and Explanation:

First we have to calculate the cost of equity which shall be calculated as follows:

Cost of equity=D0(1+g)/P0+g

In the given question:

D0=$2.25

P0=$22.00

g=growth rate=5%

Cost of common equity=$2.25(1+5%)/$22.00+5%

                       =15.74%

Now we will calculate the WACC which shall be determined through following mentioned formula:

WACC=[Portion of Equity in capital structure*Cost of equity+Portion of Debt in capital structure*Post tax cost of debt]/Portion of Equity in capital structure+Portion of Debt in capital structure

WACC=[65%*15.74%+35%*(1-40%)*8%]/100%

WACC=11.91%