Question

Pearson Motors has a target capital structure of 45% debt and 55% common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 12%, and its tax rate is 25%. Pearson's CFO estimates that the company's WACC is 12.20%. What is Pearson's cost of common equity

Answer 1

14.82 %

Step-by-step explanation:

WACC = Cost of equity x Weight of equity + Cost of Debt x Weight of Debt

where,

After tax cost of debt = Interest x (1 - tax rate)

= 12 % x (1 - 0.25)

= 9 %

therefore,

Let the Cost of equity be Ce

12.20% = Ce x 0.55 + 9 % x 0.45

12.20% = 0.55 Ce + 4.05

Ce = 14.82 %

thus

Pearson's cost of common equity is 14.82 %