Question

Rollins Corporation has a target capital structure consisting of 20% debt, 20% preferred stock, and 60% common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. It has 20-year, 12% semiannual coupon bonds that sell at their par value of $1,000. The firm could sell, at par, $100 preferred stock that pays a 12% annual dividend, but flotation costs of 5% would be incurred. Rollins’ beta is 1.2, the risk-free rate is 10%, and the market risk premium is 5%. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%. The firm’s policy is to use a risk premium of 4% when using the bond-yield-plus-risk-premium method to find rs. Flotation costs on new common stock total 10%, and the firm’s marginal tax rate is 40%.

Cost of debt

1. What is Rollins’ component cost of debt? a. 10.0% b. 9.1% c. 8.6% d. 8.0% e. 7.2%

2. What is Rollins’ cost of preferred stock? a. 10.0% b. 11.0% c. 12.0% d. 12.6% e. 13.2%

3. What is Rollins’ cost of retained earnings using the CAPM approach? a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

4. What is the firm’s cost of retained earnings using the DCF approach? a. 13.6% b. 14.1% c. 16.0%

5. What is Rollins’ cost of retained earnings using the bond-yield-plus-risk-premium approach? a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

6. What is Rollins’ WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget? a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

Answer 1

1. Cost of debt = Bond yield

As the bond sells at par value bond yield = coupon rate = 12%

So, Component cost of debt K_d = 12%

And cost after tax, K_d * (1-T) = 12 * (1 - 0.40) = 7.2%

2. Cost of preferred stock:

K_p = Dividend / [Current value * (1 - Flotation Cost)] = 12 / [100 * (1-0.05)]

K_p = 12 / 95 = 12.63% or 12.60%

3. As per CAPM, Cost of retained earnings:

K_s = Rf + beta * (Rm - Rf)

Rf = risk free rate = 10%

Rm - Rf = market risk premium = 5%

So, K_s = 10% + 1.2 * 5% = 16%

4. As per DCF, Cost of retained earnings:

K_s = [D₀ * (1+g)] / P₀] + g

Where D₀ = Recent Dividend = $2

g = Growth rate = 8% = 0.08

P₀ = Current share price = $27

K_s = [(2 * 1.08) / 27] + 0.08 = 0.08 + 0.08 = 0.16 = 16%

5. Cost of retained earnings using the bond-yield-plus-risk-premium approach:

K_s = K_d + Risk Premium

K_s = 12 + 4 = 16%

6. WACC = W_d * K_d * (1-T) + W_s * K_s + W_p * K_p

Where,

W_d = Debt weight = 20%

K_d (1-T) = 7.2%

W_s = Weight of equity = 60%

K_s = Cost of equity = 16%

W_p = Weight of preferred stock = 20%

K_p = cost of preferred stock = 12.63%

WACC = 0.20 * 7.2% + 0.60 * 16% + 0.20 * 12.63%

WACC = 13.566% or 13.60% approx.