   Chapter 10, Problem 8P Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Solutions

Chapter
Section Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

COST OF COMMON EQUITY AND WACC 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?

Summary Introduction

To identify: The cost of common equity and WACC.

Introduction:

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.

Weighted Average Cost of Capital (WACC):

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

Explanation

Cost of equity:

Given,

Last dividend is $2.25. Growth rate is 5% or 0.05. Current price of stock is$22.

The formula to calculate cost of common equity is,

rs=D0(1+g)P0+g

Where,

• D0 is the last dividend.
• rs is the rate of return on equity.
• P0 is the current price of the stock.
• g is the constant growth rate.

Substitute $2.25 for D0 ,$22 for P0 and 0.05 for g.

rs=$2.25(1+0.05)$22+0.05=0.1074+0.05=0.1574 or 15.74%

Thus cost of common equity is 15.74%.

WACC:

Given,

Weight of debt is 35%.

Weight of equity is 65%

Calculated info,

After tax cost of debt is 4.8% or 0.048.

Cost of common equity is 15.74% or 0.1574.

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

WACC=Wdrd+Wcrs

Where,

• Wd is the weight of the debt

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