10.8 Cost of common equity and WACC Patton Paints Corporation has a target capit
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10.8 Cost of common equity and WACC Patton Paints Corporation has a target capital structure of40% debt and 60% common equity,with no preferred stock. Its beforetax cost of debt is 12%, and its marginal tax rate is 40%. Thecurrent stock price is Po=$22.50. The last dividend wasD0 = $2.00,and it is expected to grow at a constant rateof 7%. What is its cost of common equiy and its WACC? 10.8 Cost of common equity and WACC Patton Paints Corporation has a target capital structure of40% debt and 60% common equity,with no preferred stock. Its beforetax cost of debt is 12%, and its marginal tax rate is 40%. Thecurrent stock price is Po=$22.50. The last dividend wasD0 = $2.00,and it is expected to grow at a constant rateof 7%. What is its cost of common equiy and its WACC?Explanation / Answer
Patton Paints Corporation target Capital Structure:
Equity - 60%
Debt - 40%
Before –tax cost of debt (RD) = 12%
Tax rate = 40%
Current Stock price(P0) = $22.50
Last Dividend(D0) = $2.00
Dividend growth rate (g) = 7%
Cost of Common equity (RE) = ?
WACC = ?
Calculating Patton Paints Corporation’s after-taxcost of debt:
After-tax cost of debt = before-tax rate * (1- marginal taxrate)
= 12% * (1-40%)
= 0.12 * 0.6
= 0.072 (or) 7.2%
After-tax cost of debt (RD) =7.2%
Calculating Patton Paints Corporation’s cost ofcommon equity (RE):
Current Stock price(P0) = $22.50
Last Dividend(D0) = $2.00
Dividend growth rate (g) = 7%
Required return (R ) = (D1/P0) + g
R = [($2 * (1.07)/$22.50] + 0.07
R = ($2.14/$22.50) + 0.07
R = 16.5%
Required return ( R) = 16.5%
Required return ( R) = Cost of Common equity (RE) +Cost of Debt (RD)
Cost of Common equity (RE) = 16.5%
Cost of Common Equity (R E) =16.5%
Calculation of weighted average cost of capital(WACC):
V = E+D
V = 60%+40%
E/V = 60 / 100 = 0.6
D/V = 40 / 100 = 0.4
WACC = (E/V) * RE + (D/V) * RD(1-Tc)
= 0.6 * 16.5% + 0.4 * 7.2%
= 0.6 * 0.165 + 0.4 * 0.072
= 0.099 + 0.0288
= 12.78%
Weighted Average Cost of Capital (WACC) =12.78%
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