Question

Palencia Paints Corporation has a target capital structure of 40% debt and 60% common equity, with no preferred stock. Its before-tax cost of debt is 13%, and its marginal tax rate is 25%. The current stock price is P0 = $27.00. The last dividend was D0 = $2.25, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC? Do not round intermediate calculations. Round your answers to two decimal places. rs = % WACC = %

Answer 1

Given,

Debt = 40%

Common equity = 60%

Before tax cost of debt = 13%

Marginal tax rate = 25% or 0.25

Current stock price = $27

Dividend = $2.25

Growth rate = 5% or 0.05

Solution :-

Cost of common equity = [{dividend x (1 + growth rate)} current stock price] + growth rate

= [{$2.25 x (1 + 0.05)} $27] + 0.05

= [{$2.25 x (1.05)} $27] + 0.05

= [$2.3625 $27] + 0.05

= 0.0875 + 0.05 = 0.1375 or 13.75%

WACC = (cost of common equity)(Common equity) + (before tax cost of debt)(1 - marginal tax rate)(debt)

= (13.75%)(60%) + (13%)(1 - 0.25)(40%)

= 8.25% + (13%)(0.75)(40%)

= 8.25% + 3.90% = 12.15%