18. the Information Below Applies to the Next Four Questions

18. The information below applies to the next four questions.

Rollins Corporation targets a capital structure of 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 of par annual dividend, but flotation costs will be 5 percent. 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 expects net income 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.

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 Rollins is 12 percent. The after-tax cost of debt equals:

rd,After-tax = 12.0%(1 - 0.40) = 7.2%.

A. What is Rollins' cost of preferred stock (including flotation costs)?

B. What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

Cost of common stock (Bond yield-plus-risk-premium approach):

ks = 12.0% + 4.0% = 16.0%.

C. What is Rollins' WACC using the cost of equity implied by the constant growth model?

= 16%

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 Rollins is 12 percent. The after-tax cost of debt equals:

rd,After-tax = 12.0%(1 - 0.40) = 7.2%.

WACC = (Weight of Debt × Cost of Debt) + (Weight of Preferred Stock × Cost of Preferred Stock) + (Weight of Common Stock × Cost of Common Stock)

= (0.2 × 7.2) + (0.2 × 12.6) + (0.6 × 16)

= 13.56%

D. What is Rollins' cost of equity using the CAPM if the firm alters their capital structure to 50% equity and 50% debt?

= 10 + 1.2(5)

= 16%

WACC = (Weight of Debt × Cost of Debt) + (Weight of Common Stock × Cost of Common Stock)

= (0.5 × 7.2) + (0.5 × 16)

= 11.60%