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Component Cost and WACC

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Johnson 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. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent.

1. What is Johnsons' component cost of debt?
2. What is Johnson ' cost of preferred stock?
3. What is Johnsons' cost of common stock (rs) using the CAPM approach?
4. What is the firm's cost of common stock (rs) using the DCF approach?
5. What is Johnsons' WACC (using the cost of equity based on the DCF approach)?

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Solution Preview

1)What is Johnsons' component cost of debt?

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Johnson is 12 percent.
For component cost of debt we take the after tax cost since interest is tax deductible. The after-tax cost of debt ...

Solution Summary

The solution explains how to calculate the component cost of capital and the WACC.