Question

Pearson Motors has a target capital structure of 45% debt and 55% common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 10%, and its tax rate is 40%. Pearson's CFO estimates that the company's WACC is 14.50%. What is Pearson's cost of common equity

Answer 1

21.45%

Step-by-step explanation:

Pearson motors has a target capital structure of 45% debt and 55% common equity

The yield to maturity is 10%

Tax rate is 40%

WACC is 14.50%

First of all we have to find the tax cost of debt

Tax cost of debt= Yield to maturity×(1-tax rate)

= 8×(1-25/100)

= 8×(1-0.25)

= 8×0.75

= 6%

The next step is to calculate the common equity

Therefore, the common equity can be calculated as follows

WACC= Respective cost×Respective weight

14.50= (6×0.45)+(0.55×common equity)

14.50= 2.7+(0.55×common equity)

14.50-2.7= (0.55×common equity)

11.8= (0.55×common equity)

Common equity= 11.8/0.55

Common equity= 21.45%

Hence Pearson's cost of common equity is 21.45%