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 = $34.50. The last dividend was D0 = $3.00, and it is expected to grow at a 6% 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.

Answer 1

K_e = (D₁ / P₀ ) +g

P₀ = Current Market Price

D₁ = Dividend of current year

D₁ = D₀ (1+g)

Ke = Cost of Equity

g = Growth Rate

Given :

P₀ = Current Market Price = $34.50

D₁ = Dividend of current year = ?

D₀ = Last Dividend = $3.00

Ke = Cost of Equity = ?

g = Growth Rate = 6%

Debt = 35%

Equity = 65%

Solution :

Note 1 : Calculation of D₁ i.e dividend of current year

D₁ = D₀ (1+g)

D₁ = $3 (1+ .06)

D₁ = $3.18

Cost of Common Equity :

K_e = (D₁ / P₀ ) +g

K_e = ($3.18 / $34.50) + 0.06

K_e = .0922 + .06

K_e = 15.22%

WACC = (Cost of Equity * Percent of Equity to Total Capital) +

(After Tax Cost of Debt * Percent of Debt to Total Capital)

WACC = (15.22 * 65%) + [8 (1-.4) * 35%)

WACC = 9.89% + (4.8 * 35%)

WACC = 9.89% + 1.68%

WACC = 11.57%