Rollins Corporation is constructing its MCC schedule. Its 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 $1,000. The firm could sell, at par, $100 preferred stock, which 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 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 k(s). 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' cost of retained earnings using the bond-yield-plus-risk-premium approach?
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A. B. C. D. E.B
Cost of retained earnings (Bond yield plus risk premium approach): k(s) = 12.0% + 4.0% = 16.0%.
To calculate Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach, we need to follow these steps:
Step 1: Calculate the cost of debt (kd). The bond's coupon rate is 12% and is paid semiannually. The current market price of the bond is $1,000. Since the bond sells at par, the coupon rate is equal to the yield to maturity (YTM).
Since the coupon is paid semiannually, we need to adjust the rate accordingly. The coupon payment is $1,000 * 12% / 2 = $60. The number of periods is 20 years * 2 = 40.
Using these values, we can calculate the yield to maturity (YTM) using a financial calculator or Excel's RATE function: PV = -$1,000 FV = $1,000 N = 40 PMT = $60
Solving for the interest rate, we find that kd ≈ 6%.
Step 2: Calculate the cost of preferred stock (kp). The preferred stock pays a 12% annual dividend. However, there are flotation costs of 5%. Therefore, the effective cost of preferred stock is:
kp = Dividend / Net Proceeds kp = 12% / (1 - 0.05) kp ≈ 12.63%
Step 3: Calculate the cost of common equity (ke). We can use the capital asset pricing model (CAPM) to calculate the cost of common equity.
ke = Risk-Free Rate + Beta * Market Risk Premium ke = 10% + 1.2 * 5% ke ≈ 16%
Step 4: Calculate the cost of retained earnings (kr). To calculate the cost of retained earnings, we need to determine the required return on equity (k(equity)). The formula for k(equity) is:
k(equity) = (Dividend / Current Stock Price) + Growth Rate
Dividend = Dividend Payout Ratio * Net Income Dividend = 40% * $1 million = $400,000
k(equity) = ($400,000 / $27.00) + 8% k(equity) ≈ 14.81% + 8% k(equity) ≈ 22.81%
Finally, to calculate the cost of retained earnings (kr), we need to apply the risk premium:
kr = k(equity) - Risk Premium kr = 22.81% - 4% kr ≈ 18.81%
The closest answer choice to 18.81% is 16.9% (answer choice C).