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 = $28.50. The last dividend was D₀ = $3.00, and it is expected to grow at a 7% 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.

Answer 1

Information provided:

Weight of debt in the capital structure= 35%

Weight if equity in the capital structure= 65%

Before tax cost of debt= 9%

Tax rate= 40%

Current stock price= $28.50

Last dividend= $3

Growth rate= 7%

The cost of common equity is calculated with the help of 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= $3*(1+ 0.07)/ $28.50 + 0.07

     = 3.21/ $28.50 + 0.07

     = 0.1126 + 0.07

     = 0.1826*100

     = 18.26%

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*9*(1 – 0.40) + 0.65*18.26

            = 1.89% + 11.87%

            = 13.76%

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