Question

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 12% and its marginal tax rate is 25%. The current stock price is P0 = $34.00. The last dividend was D0 = $4.00, and it is expected to grow at a 4% constant rate.

Required:
1. 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

The cost of common equity is 15.76% while WACC is 14.07%

Step-by-step explanation:

The cost of common equity can be derived from the price formula given below:

Price=dividend/(rate of return-growth rate)

where rate of return is the cost of common equity

price is $34

dividend is $4

growth rate is 4%

rate of return is unknown

34=4/(rate of return-0.04)

let the rate of return be taken as x

34=4/(x-0.04)

by cross multiplication we have

34(x-0.04)=4

34x-1.36=4

34x=4+1.36

34x=5.36

x=5.36/34

x=0.157647059

x=15.76%

WACC=E/V* Re+D/V*Rd*(1-t)

E is equity weighting

V is total weighting

D is debt weighting

Re is the cost of equity

Rd is the cost of debt

WACC=(75%/100%)*15.76%+(25%/100%)*12%*(1-0.25)

WACC=0.1182 +0.0225

WACC=0.1407

WACC=14.07%