Question

Pearson Motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 12%, and its tax rate is 40%. Pearson's CFO estimates that the company's WACC is 13.70%. What is Pearson's cost of common equity

Answer 1

Answer:

Cost of common equity is 16.49%

Explanation:

The WACC of weighted average cost of capital is the cost of a firm's capital structure. The capital structure of the firm can comprise of the following components namely debt, preferred stock and common stock.

For a firm which has only debt and equity, the WACC is calculated as follows,

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

Where,

• w represents the weight of each component
• r represents the cost of each component
• we multiply the cost of debt (rD) by (1 - tax rate) to calculate the after tax cost of debt

Plugging in the values of the available components, we can calculate the cost of common equity to be,

0.1370 =  0.3 * 0.12 * (1 - 0.4)  +  0.7 * rE

0.1370 = 0.0216 + 0.7 * rE

0.1370 - 0.0216  = 0.7 * rE

0.1154 / 0.7  =  rE

rE = 0.164857  or  16.4857%    rounded off to 16.49%