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Patton Paints Corporation has a target capital structure of 40% debt and 60% common equity, with no preferred stock. Its before-tax cost of debt is 13% and its marginal tax rate is 40%. The current stock price is P0 = $22.00. The last dividend was D0 = $4.00, and it is expected to grow at a 8% constant rate. What is its cost of common equity and its WACC?

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beritop1089

Answer:

19.7%

Explanation:

WACC is the weighted average cost of capital for a firm that has both debt and equity in its capital structure. The formula is as follows;

WACC = wE*re + wD*rD(1-tax)

First, find cost of equity using dividend discount model;

r = (D1/P0 ) -g

where D1 = next year's dividend; D1 = D0(1+g)

4(1.08) = 4.32

r = (4.32/22)- 0.08

r = 0.2764 or 27.64%

WACC = (0.60 * 0.2764) + [ 0.40*0.13(1-0.40)]

WACC=0.1658 + 0.0312

WACC = 0.197 or 19.7%

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