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Rollins Corporation’s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent...

Rollins Corporation’s 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 $1,200 in the market now. The price of firm’s newly issued preferred stock is $100 and the flotation cost is 5 percent. The company pays an annual dividend of $12 to its preferred stockholders. Rollins' beta is 1.2, the risk‑free rate is 10 percent, and the market risk premium (which is the difference between market return and risk free rate) 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 Debt -cost-plus-risk-premium method to find ks. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.

What is Rollins' lowest WACC?

A.

13.6%

B.

14.1%

C.

16.0%

D.

16.6%

E.

16.9%

Solutions

Expert Solution

Cost of debt:
Present Value PV          1,000
FV (par value)          1,000
Coupon rate r 12%
Coupon payment p = FV*r/2                60
Number of payments N                40
Semi-annual yield y = rate(N, p, -PV, FV) 6.00%
Annualized yield Y = y*2 12.00%
Tax rate T 40%
After-tax cost of debt Y*(1-T) 7.20%
Cost of preferred stock:
Current price p            100
Flotation cost f 5%
Annual dividend D               12
Cost of preferred stock D/(p*(1-f)) 12.63%
Cost of common stock - using CAPM
Risk-free rate rf 10%
Market risk premium R 5%
Beta b 1.2
Cost of equity rf + (b*R) 16.00%
Cost of issuing new common stock - using dividend growth model
Dividend D            2.00
Expected dividend D1 = D*(1+g)            2.16
Current price P         27.00
Growth rate g 8%
flotation cost f 10%
Cost of equity (D1/P*(1-f)) + g 16.89%

If cost of common stock is calculated using the above dividend growth model but without flotation cost, it will be 16%.

Cost of common stock - using cost plus risk premium
Annualized yield Y 12.00%
Additional risk premium Ar 4%
Cost of equity (Y+Ar) 16.00%

The lowest cost of equity is 16% so that will be taken for WACC calculation.

Bond Preferred stock Common stock
Weight (w) 20% 20% 60%
Cost ('c) 7.20% 12.63% 16.00%
Weighted cost (w*c) 1.44% 2.53% 9.60%
WACC 13.57%

Lowest WACC = 13.57% (option A)

Note: There is a typo in the question. The current bond price has to be $1,000 otherwise WACC won't match any of the given options.

jeff jeffy answered 9 months ago
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