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 10%, and its marginal tax rate is 25%. 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?

(A) Cost of equity= 15.74%

(B) WACC = 12.86%

Explanation:

Palencia paint corporation has a 35% debt from it's target capital structure and 65% common equity

The before-tax cost debt is 10%

Marginal tax rate is 25%

Po is $22.00

Do is $2.25

Constant rate(g) is 5%

(A) The cost of common equity can be calculated as follows

= [Do(1+g)/Po] + g

=[2.25(1+0.05)/22] + 5%

= [2.25(1.05)/22] + 5%

= 2.3625/22 + 5%

= 0.1074+5%

= 0.1074×100+5%

= 10.74%+5%

Cost of equity = 15.74%

(B) The WACC can be calculated as follows

= weight of debt×after-tax cost of debt + weight of equity×cost of equity

= (35%)(10%)(1-25%) + (65%)(15.74%)

= (35%)(10%)(1-0.25) + (65%)(15.74%)

=(35%)(10%)(0.75) + (65%)(15.74%)

= 2.63% + 10.23%

= 12.86%

Hence the cost of equity is 15.74% and the WACC is 12.86%

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