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 10%, and its marginal tax rate is 25%. The current stock price is P0 = $26.00. The last dividend was D0 = $2.75, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC? Do not round intermediate calculations. Round your answers to two decimal places.

cost of equity or r = 0.1610576923 or 16.10576923% rounded off to 16.11%

WACC = 0.1309375 or 13.09375% rounded off to 13.09%

Explanation:

The constant growth model of DDM is used to value stock paying a dividend which is growing at a constant rate. The formula for price today of such a stock is,

P0 = D0 * (1+g)/ r - g

Where,

By plugging in the values of P0, D0 and g in the formula we can calculate r,

26 = 2.75 * (1+0.05) / (r - 0.05)

26 * (r - 0.05)  =  2.8875

26r - 1.3  =  2.8875

26r = 2.8875 + 1.3

r = 4.1875 / 26

r = 0.1610576923 or 16.10576923% rounded off to 16.11%

Cost of common equity is 16.11%

The WACC or weighted average cost of capital is the cost of a firm's capital structure. The capital structure contains at least one of at most all of the following components namely debt, preferred stock and common equity.

The WACC for a company having only debt and common equity is calculated as follows,

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

Where,

WACC = 0.35 * 0.1 * (1 - 0.25)  +  0.65 * 0.1610576923

WACC = 0.1309375 or 13.09375% rounded off to 13.09%