Question

COST OF COMMON EQUITY AND WACC Palencia Paints Corporation has a target capital structure of 30% debt and 70% common equity, with no preferred stock. Its before-tax cost of debt is 13% and its marginal tax rate is 40%. The current stock price is Po-$31.50. The last dividend was D0 = $2.25, and it is expected to grow at a 4% 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. a, r b, WACC

Answer 1

a) Cost of equity can be calculated using constant growth dividend discount model

Div Po=- Po Price of Stock Divi = Estimated Dividends for Next Period r = Required Rate of Return g Grouth Rate

Div1 = $2.25 * (1 + 4%) = $2.34

2.34 31.50 = 0.04

r - 0.04 = 0.0743

r = 11.43%

b) WACC = Weight of debt * Pretax cost * (1 - Tax) + Weight of Equity * Cost of Equity

WACC = 30% * 13% * (1 - 40%) + 70% * 11.43%

WACC = 2.34% + 8% = 10.34%