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 25%. Pearson's CFO estimates that the company's WACC is 13.00%. What is Pearson's cost of common equity

Answer 1

0.175 or 17.5%

Explanation:

The calculation of the cost of common equity is shown below:-

WACC = Weight of Equity × Cost of Equity + Weight of Debt × ( 1- Tax rate) × Cost of Debt

0.13 = (0.55 × Cost of equity) + ((0.45 × (1 - 0.25) × 0.10)

0.13 = (0.55 × Cost of equity) + 0.045 × 0.75

(0.55 × Cost of equity) = 0.13 - 0.03375

(0.55 × Cost of equity) = 0.09625

Cost of equity = 0.09625 ÷ 0.55

= 0.175

Therefore for computing the cost of equity we simply applied the above formula.