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 = $33.50. The last dividend was D₀ = $3.50, and it is expected to grow at a 4% constant rate. What is its cost of common equity and its WACC? Do not round intermediate calculations. Round your answers to two decimal places.

1. r_s =   %
2. 
   
3. WACC =  

Answer 1

For a dividend growth model firm

Price today(p0) =divendend for next year /(cost of equity - growth rate)

Where dividend for next year = dividend for current year *(1+growth rate)

Given p0=33.5

Current year dividend = 3.50

Hence

33.50=3.50*(1+4%)/(cost of equity - 4%)

Cost of equity - 4%=3.64/33.50

Cost of equity =0.108656+0.04

=0.148656

=14.8656% or 14.87%

Hence cost of equity =14.87%

Given pre tax cost of debt = 8%

Hence post tax cost of debt =8%*(1-tax rate)

=8%*(1-40%)

=4.8%

We know that WACC= weight of debt * post tax cost of debt+ weight of equity * cost of equity

=35%*4.8%+14.8656%*65%

= 1.68%+9.66264%

=11.34264% or 11.34%

Hence wacc =11.34%