Percy Motors has a target capital structure of 40% debt and 60% common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 9%, and its tax rate is 40%. Percy's CFO estimates that the company's WACC is 9.96%. What is Percy's cost of common equity? (HINT: Without preferred stock, so WACC= (wd)(rd)(1-T)+(wc)(rs). Given WACC, rd, wd, wc, and T, solve the cost of common equity, rs)

Solution

Cost of Capital
Percy Motors has a target capital structure of 40 percent debt and 60 percent common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 9 percent, and its tax rate is 40 percent. Percy's CFO estimates that the company's WACC is 9.96 percent. What is Percy's cost of common equity?
WACC = WdKd(1 - T) + WcKs where Wd is the weight of debt
Kd is the cost of debt
T is the tax rate
Wc is the weight of common stock
Ks is the cost of common stock

Then, we can replace the information found to find WACC.

WACC = WdKd(1 - T) + WcKs
= [0.40 x 0.09(1 - 0.40)] + (0.60 x Ks)
0.0996 = 0.0216 + 0.60Ks
Ks = 0.13

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