Question

Cost of Common Equity and WACC

Palencia Paints Corporation has a target capital structure of 25% debt and 75% common equity, with no preferred stock. Its before-tax cost of debt is 13% and its marginal tax rate is 40%. The current stock price is P0 = $21.50. The last dividend was D0 = $2.75, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC? Round your answers to two decimal places. Do not round your intermediate calculations.

rs = _______%

WACC = _________ %

Cost of Equity with and without Flotation

Jarett & Sons's common stock currently trades at $26.00 a share. It is expected to pay an annual dividend of $3.00 a share at the end of the year (D1 = $3.00), and the constant growth rate is 5% a year.

What is the company's cost of common equity if all of its equity comes from retained earnings? Round your answer to two decimal places. Do not round your intermediate calculations.
________%

If the company issued new stock, it would incur a 11% flotation cost. What would be the cost of equity from new stock? Round your answer to two decimal places. Do not round your intermediate calculations.
_________ %

Answer 1

Cost of Common Equity and WACC:

Given, last dividend= $2.75

Dividend growth rate= 5%

Stock price= $21.50

So, 21.50 = 2.75*1.05/(rs-0.05), where r is the cost of common equity

rs = 18.43%

After tax cost of debt= (1-0.40)*13= 7.8%

So, WACC= 0.25*7.8 + 0.75*18.43 = 15.77%

Cost of Equity with and without Flotation:

Stock Price= $26

Dividend next year= $3

Growth rate= 5%

So, 26= 3/(rs-0.05), where rs is cost of common equity without floatation cost

rs= 16.54 %

Floatation cost=11%

So, 26*(1-0.11) = 3/(rs'-0.05), where rs' is cost of common equity with floatation cost

rs'= 17.96%