Rollins Corporation is constructing its MCC (marginal cost of capital) schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12percent 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)
(component cost of retained earnings). 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 CAPM (Capital Asset Pricing
Model) approach?
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A. B. C. D. E.A
Cost of retained earnings (CAPM approach): k(s) (component cost of retained earnings) = 10% + 1.2(5%) = 16.0%.
To calculate Rollins Corporation's cost of retained earnings using the CAPM (Capital Asset Pricing Model) approach, we need to follow these steps:
Calculate the risk-free rate: The risk-free rate is given as 10 percent.
Calculate the market risk premium: The market risk premium is given as 5 percent.
Calculate the beta (β) for Rollins Corporation: Rollins' beta is given as 1.2.
Calculate the equity risk premium: The equity risk premium is calculated by multiplying the market risk premium by the beta.
Equity Risk Premium = Market Risk Premium * Beta = 5% * 1.2 = 6%
Calculate the cost of equity (k(e)) using the CAPM formula:
Cost of Equity (k(e)) = Risk-Free Rate + Equity Risk Premium = 10% + 6% = 16%
Adjust the cost of equity for the firm's growth rate using the Gordon growth model:
Cost of Retained Earnings (k(s)) = Cost of Equity / (1 - Dividend Payout Ratio) = 16% / (1 - 0.40) = 16% / 0.60 = 26.67%
However, 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). So, we need to adjust the cost of retained earnings.
Adjust the cost of retained earnings using the risk premium:
Adjusted Cost of Retained Earnings (k(s)) = Cost of Retained Earnings - Risk Premium = 26.67% - 4% = 22.67%
Therefore, the cost of retained earnings using the CAPM approach for Rollins Corporation is approximately 22.67%.
Among the given answer choices, the closest option is C. 16.9%. However, none of the provided answer choices match the calculated value exactly.