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) (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 the firm's cost of retained earnings using the DCF approach?
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Cost of retained earnings (DCF approach): k(s) = $2.16/'$27.00 + 8% = 16.0%.
To calculate the cost of retained earnings (k(s)) using the Discounted Cash Flow (DCF) approach, we need to consider the dividend growth model. The formula for the cost of equity using the DCF approach is:
k(s) = (D1 / P0) + g
where: D1 = expected dividend per share one year from now P0 = current market price per share g = dividend growth rate
Let's calculate the various components step by step:
Since the dividend payout ratio is 40 percent, the retained earnings available for dividends would be distributed as dividends, and the remaining portion would be retained.
The expected dividend per share (D1) can be calculated by dividing the retained earnings by the number of shares outstanding: D1 = Retained Earnings / Number of Shares Outstanding
To calculate the number of shares outstanding, we divide the market value of equity (common stock) by the stock price: Number of Shares Outstanding = Market Value of Equity / Stock Price Market Value of Equity = Market Price per Share * Number of Shares Outstanding Given: Market Price per Share = $27.00
We are not given the number of shares outstanding directly, so we need to calculate it using the market value of equity.
Market Value of Equity = D1 / (k(e) - g)
where k(e) is the required rate of return on equity.
To calculate k(e), we use the Capital Asset Pricing Model (CAPM): k(e) = R(f) + β * (R(m) - R(f))
where: R(f) = risk-free rate β = beta R(m) = market risk premium
Given: R(f) = 10% β = 1.2 R(m) = 5%
Substituting the values: k(e) = 10% + 1.2 * 5% = 16%
Now, substitute the value of k(e) and the given values of D1 and g into the Gordon growth model to find the market value of equity.
Calculate the market value of equity (continued): Market Value of Equity = D1 / (k(e) - g) Market Value of Equity = $600,000 / (16% - 8%) = $600,000 / 8% = $7,500,000
Calculate the number of shares outstanding: Number of Shares Outstanding = Market Value of Equity / Stock Price Number of Shares Outstanding = $7,500,000 / $27.00 ≈ 277,778 shares
Now, we have all the required values to calculate the cost of retained earnings (k(s)) using the DCF approach.