Fundamentals of Financial Manageme...

9th Edition

Eugene F. Brigham + 1 other

ISBN: 9781305635937

Textbook Problem

COST OF COMMON EQUITY Pearson Motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 40%. Pearson’s CFO estimates that the company’s WACC is 10.50%. What is Pearson’s cost of common equity?

Summary Introduction

To determine: The cost of equity for P Motors.

Introduction:

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the sources through which a firm finances its capital. It is the rate that a company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is computed by taking the relative weight of each item of the capital structure.

Cost of Equity:

It is the cost of the company while raising finance by issuing equity. It is earnings from the investment to the firm’s equity investors. It is the return to the stockholder’s equity investments.

Explanation

Given information:

WACC is 10.50% or 0.1050.

Weight of debt is 30% or 0.30.

Cost of debt is 9% or 0.09.

Weight of equity is 70% or 0.70.

Tax rate is 40% or 0.40.

The company does not have any preferred stock, the formula to calculate WACC is,

WACC=Wdrd(1−t)+Wcrs

Where,

Wd is the weight of the debt.
Wc is the weight of the equity.
rd is cost of the debt.
rc is the cost of the equity.
t is the tax rate.

Substitute 10

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Finance Fundamentals of Financial Management, Concise Edition (MindTap Course List)9th Edition