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 8%, and its marginal tax rate is 40%. The current stock price is P₀$22.00. The last dividend was D₀$2.25, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC?

Answer 1

Information provided:

Weight of debt in the capital structure= 35%

Weight of equity in the capital structure= 65%

Tax= 40%

Before tax cost of debt= 8%

Current price of stock= $22

Previous dividend= $2.25

Growth rate= 5%

The cost of common equity is calculated using the dividend discount model.

It 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= Cost of equity

Ke= $2.25*(1+ 0.05)/ $22 + 0.05

     = $2.36/ $22 + 0.05

     = 0.1073 + 0.05

     = 0.1573*100

     = 15.73%.

Therefore, the cost of common equity is 15.73%.

WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.35*8*(1-0.40) + 0.65*15.73

            = 1.68 %+ 10.22%

            = 11.90 %.

Therefore, the weighted average cost of capital is 11.90 %.

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