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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

COST OF COMMON EQUITY Percy Motors has a target capital structure of 40% debt and 60% common equity, with no preferred stock. The yield to maturity on the company’s outstanding bonds is 9%. and its tax rate is 40%. Percy’s CFO estimates that the company’s WACC is 9.96%. What is Percy’s cost of common equity?

Summary Introduction

To determine: The cost of equity of P motors.

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the sources through which the firm finances its capital. It is that rate that company will pay to all for raising finance. It can be termed as firm’s cost of capital.

The company raises money through various sources such as common stock, preference share debt, the WACC is calculated taking the relative weight of each item of capital structure.

The formula to calculate WACC is,

WACC=Wdrd(1t)+WPrp+Wcrs

Where,

  • Wd is the weight of the debt.
  • WP is the weight of the preferred stock.
  • Wc is the weight of the equity.
  • rd is cost of the debt.
  • rP is cost of the preferred stock.
  • rc is the cost of the equity.

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 holders’ equity investments.

Explanation

Given,

WACC is 9.96%.

Weight of debt is 40%.

Cost of debt is 9%.

Weight of equity is 60%.

Tax rate is 40%.

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

WACC=Wdrd(1t)+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 9.96% for WACC, 0.40 for Wd, 0

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