Instructions: Read each problem carefully, and answer the question that follows.

Question

Instructions: Read each problem carefully, and answer the question that follows. Provide the necessary computation to support you answer. 1. 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? 2. Tunney Industries can issue perpetual preferred stock at a price of $47.50 a share. The stock would pay a constant annual dividend of $3.80 a share What is the company's cost of preferred stock, rp?

Explanation / Answer

1. Ratio of debt: equit = 4:6

Cost of debt = 9%

WACC = 9.96%

Let cost of equity be x

Hence, 9*4/10*(1-.4)+x*6/10 = 9.96

By solving this equiation, we get:

x = 13%

Hence, cost of equity = 13%

2. Cost of preferred stock = 3.80/47.50*100 = 8%

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