Hanover inc. has a target capital structure consisting of 30 percent debt, 10 pe

Question

Hanover inc. has a target capital structure consisting of 30 percent debt, 10 percent preferred stock and 60 percent common equity. its bonds have a maturity of $1,000, a 10 percent coupon, paid semiannually, a current maturity of 20 years, and seek for $1000. the firm could sell, at par, $100 preferred stock that 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 8 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.50, sells for $26.00 per share, and has a growth rate of 9 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. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. what is Hanover's WACC?

Explanation / Answer

cost of debt = YTM

Let the YTM be "x". Thus, using the principle of present value, the present value of all future coupon payments and maturity value should be $1,000. Semi-annual coupon payments = 10%/2*1,000 = $50. 40 such payments will be made.

Thus, 1,000 = 50/(1+x)^0.5+50/(1+x)^1+50/(1+x)^1.5........50/(1+x)^20+1,000/(1+x)^20

Solving using a trial and error method, x = 10.25%

This is the YTM. After tax cost of debt = (1-tax rate)*YTM = (1-40%)*10.25% = 6.15%

cost of preference shares = Dividend rate/(1-floatation cost) = 12%/(1-5%) = 12.63%

cost of equity = risk free rate+beta*(market risk premium) = 8%+1.2*5 = 8%+6% = 14%

(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). Hence cost of equity = 14%+4% = 18%

cost of equity calculating the dividend discount model = next year's dividend/current price + growth rate of dividends

= (2.50*1.09)/26 + 9% = 0.19481 or 19.481%. cost, after considering the flotation cost = 19.481%/(1-flotation cost) = 19.481%/(1-10%) = 21.65%

WACC = cost of debt*weight of debt + cost of preferred stock*weight of preferred stock + cost of equity*weight of equity

= 6.15%*0.3 + 12.63%*0.1 + 21.65%*0.6

= 1.845+1.263+12.99

= 16.098%

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