Rollins Corporation is estimating its WACC. Its target capital structure is 20%
ID: 2717428 • Letter: R
Question
Rollins Corporation is estimating its WACC. Its target capital structure is 20% debt, 20% preferred stock, and 60% common equity. Its bonds have a 12% coupon, paid semi-annually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which 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 which just paid a dividend of $2.00, sell for $27.00 per share, and has a growth rate of 8%.
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.
21. What is Rollins’ component cost of debt?
22. What is Rollins’ cost of preferred stock?
23. What is Rollins’ cost of common stock (rs) using the CAPM approach?
24. What is the firm’s cost of common stock (rs) using the DCF approach?
25. What is Rollins’ cost of common stock using the bond-yield-plus-risk-premium approach?
26. What is Rollins’ WACC?
Explanation / Answer
21)
Since Bonds is trading at par
Before Tax Cost of Debt = Coupon Rate
Before Tax Cost of Debt = 12%
After Tax Cost of Debt = Before Tax Cost of Debt *(1-tax rate)
After Tax Cost of Debt = 12*(1-40%)
After Tax Cost of Debt = 7.2%
22)
Cost of Preferred Stock = Prefered Stock Dividend/(Price - Flotation cost)
Cost of Preferred Stock = 12/(100-5%*100)
Cost of Preferred Stock = 12.63%
23)
Cost of common stock (rs) using the CAPM approach = risk-free rate + market risk premium*beta
Cost of common stock (rs) using the CAPM approach = 10 + 5*1.2
Cost of common stock (rs) using the CAPM approach = 16%
24)
Cost of common stock (rs) using the DCF approach = Expected Dividend/Share Price + Growth rate
Cost of common stock (rs) using the DCF approach = 2*1.08/27 +8%
Cost of common stock (rs) using the DCF approach = 16%
25)
Cost of common stock using the bond-yield-plus-risk-premium approach =Bond Yield + risk premium
Cost of common stock using the bond-yield-plus-risk-premium approach = 12% + 4%
Cost of common stock using the bond-yield-plus-risk-premium approach = 16%
27)
WACC = Weight of Common Stock* Cost of Common Stock + Weight of Preferred Stock* Cost of Preferred Stock + Weight of Debt* After Tax cost of Debt
WACC = 60%*16 + 20%*12.63 + 20%*7.2
WACC = 13.57%
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