Question

COST OF COMMON EQUITY AND WACC

Palencia Paints Corporation has a target capital structure of 45% debt and 55% common equity, with no preferred stock. Its before-tax cost of debt is 10%, and its marginal tax rate is 40%. The current stock price is P₀ = $24.00. The last dividend was D₀ = $2.75, and it is expected to grow at a 8% 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.

r_s = %

WACC = %

Answer 1

Current Stock Price = Expected Dividend / (Required Rate of return - growth rate)

or Required Rate of return = (Expected Dividend / Current Price ) + Growth Rate

Required Rate of return  = [( 2.75 * 108%) / $ 24 ] + 8%

Required Rate of return  = 20.375%

Hence The correct answer is :

rs = 20.38%

After Tax Cost of Debt = before-tax cost of debt * ( 1- Tax Rate)

= 10 % * ( 1- 40%)

= 6.00%

WACC = Cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity

= 6 % * 45 % + ( 20.375% * 55%)

= 2.70% +11.20625%

= 13.91%

Hence the correct answer is

WACC = 13.91%