Question

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 9%, and its marginal tax rate is 25%. The current stock price is P0 = $21.50. The last dividend was D0 = $2.50, and it is expected to grow at a 4% constant rate. What is the rs? What is its cost of common equity and its WACC?

Answer 1

We Know that,

Share Price = Dividend for current year ( D0) * ( 1 + Growth rate) / ( Cost of Equity - Growth rate)

21.50 = 2.50 * ( 1 + 4%) / ( Ke - 4%)

21.50 = 2.60 / ( Ke - 0.04)

( Ke - 0.04)= 2.60 / 21.50

Ke - 0.04 = 0.1209302

Ke (Cost of equity) = 0.1609302 or 16.09302%

Weighted average cost of capital = Weight of Debt * Cost of debt * ( 1 - Tax rate) + weight of equity * cost of equity

= 45% * 9% * ( 1 - 25%) + 55% *  16.09302%

= 0.11888661 or 11.888%

So, The WACC is 11.888%