Pearson 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 8%, 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? Round your answer to two decimal places.

rE= 0.163333 or 16.3333% rounded off to 16.33%

Explanation:

The WACC or weighted average cost of capital is the cost of a firm's capital structure which can contain one or more of the following components namely debt, preferred stock and common equity. The formula to calculate WACC of a firm with only two components including debt and equity is as follows,

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

Where,

To calculate the cost of equity, we can plug in the values of remaining variables as given in the question in the above formula,

0.122= 0.4 * 0.08 * (1 - 0.25)  +  0.6 * rE

0.122 = 0.024 + 0.6 * rE

0.122 - 0.024  =  0.6 * rE

rE = 0.098 / 0.6

rE= 0.163333 or 16.3333% rounded off to 16.33%

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