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 9%, and its marginal tax rate is 40%. The current stock price is P₀ = $21.50. The last dividend was D₀ = $2.00, 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.

1. r_s = _______ %
2. WACC = ________ %

Answer 1

The cost of common stock can be solved using dividend discount model.

Information provided:

Last dividend payment= $2

Dividend growth rate= 6%

Current stock price= $21.50

The cost of common stock is calculated using the below formula:

Ke=D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= $2*(1 + 0.06)/ $21.50 + 0.06

     = $2.12/ $21.50 + 0.06

     = 0.0986 + 0.06

     = 0.1586*100

     = 15.86%.

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+ We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.35*9*(1 – 0.40) + 0.65*15.86%

            = 0.35*5.40% + 0.65*15.86%

            = 1.89% + 10.31%

            = 12.20%.

In case of any query, kindly comment on the solution.