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?

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%