Question

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon rate paid semiannually, a current maturity of 20 years, and a price of $1,000. The firm could sell preferred stock dividends at $12 with a price of $100. Rollins's beta is 1.2, the risk-free rate is 11 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm, which expects a dividend next period of $2.16, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's marginal tax rate is 40 percent. (1) What is Rollins's component cost of debt?? (2) What is Rollins’s cost of common stock? ?

Answer 1

WACC = Cost of Equity * Weight of Equity + Pretax Cost of debt * (1 -tax rate) * Weight of debt + Weight of preferred equity * Cost of Preferred Equity

Cost of debt = 12% (since the price of bond is $1,000, equivalent to par value)

Since par value = current price, coupon rate = YTM

Post tax cost of debt = 12% * (1 - 40%) = 7.2%

Cost of Preferred Equity = Annual dividend/Current price = 12/100 = 12%

We can calculate cost of equity, using the constant growth dividend discount model,

Substituting values in this formula,

r = 16% --> Cost of common stock

WACC = (20% * 7.2%) + (20% * 12%) + (60% * 16%) = 13.44%