Question

Pearson Motors has a target capital structure of 45% debt and 55% common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 10%, and its tax rate is 40%. Pearson's CFO estimates that the company's WACC is 11.50%. What is Pearson's cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Answer:

The Pearson's cost of common equity is 16.00%

Explanation:

For computing the cost of common equity, following formula should be used which is shown below:

WACC = (Equity portion × total cost of equity) + (debt portion × total cost of debt) × (1 - tax rate)

11.50% = (0.55 × total cost of equity) + (0.45 × 0.10) × (1 - 0.40)

11.50% = (0.55 × total cost of equity) + 0.045 × 0.60

11.50% = (0.55 × total cost of equity) + 0.027

11.50% - 2.70% = (0.55 × total cost of equity)

8.80% ÷ 0.55 = total cost of equity

So, total cost of equity = 16.00%

Hence, the Pearson's cost of common equity is 16.00%