Question

Lipscomb 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, paid semiannually, a current maturity of 20 years, and sell for 1,000 USD. The firm could sell, at par, 100 USD preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Libscomb is a constant-growth firm which just paid a dividend of $2.00, sells for 27.00 USD per share, and has a growth rate of 8 percent. The firm's marginal tax rate is 40.
Required:
a. What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?
b. What is Rollins' WACC?

Answer 1

Answer:

a. 16%

b.  13.566%

Explanation:

The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.

DATA

P is price = 27

G is growth = 8%

Tax rate = 40%

Requirement a.

When the market rate of bond is equal to par value then yield is equal to the coupon rate

Tax rate = 12(1-0.4) = 7.2%

Cost of preferred stock = dividend/price

There will be a 5% floatation cost so net proceeds is 95

Cost of preferred stock = 12/95 = 12.63%

Cost of equity = D1/P + g

Where D1 is dividend for year 1 = 2+8% = 2.16

Cost of equity = 2.16/27 + 0.08

Cost of equity = 16%

Requirement  b

Wacc = 7.2×20% + 12.63×20% + 16×60%

Wacc = 13.566%