Rollins Corporation MCC Schedule: Retained Earnings Break Point

Retained Earnings Break Point

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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' retained earnings break point?

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A. B. C. D. E.

B

Retained earnings = 0.6($1,000,000) = $600,000.

BP(RE) = $600,000/0.6 = $1,000,000.

To find Rollins' retained earnings break point, we need to calculate the amount of additional equity financing required to maintain the target capital structure. The retained earnings break point is the point at which new equity financing is required because retained earnings are not sufficient to meet the equity portion of the capital structure.

Let's calculate the retained earnings break point step by step:

  1. Calculate the cost of debt (k(d)): The bonds have a 12% coupon rate, paid semiannually, and a current maturity of 20 years. Since the bonds sell for $1,000, the coupon payment per period is $1,000 * 12% / 2 = $60. The market interest rate is determined by the bond's yield to maturity. We need to find the yield to maturity using the present value formula for the bond's cash flows.

    N = 20 (number of periods) PMT = $60 (coupon payment per period) FV = $1,000 (face value) PV = -$1,000 (since it's the cost to buy the bond)

    Using a financial calculator or spreadsheet, solving for the yield to maturity (YTM) gives us approximately 6% (3% semiannually).

    Since the bond-yield-plus-risk-premium method is used to find k(s), the risk-free rate is 10%, and the risk premium is 4%, the cost of debt (k(d)) is: k(d) = YTM + risk premium = 6% + 4% = 10%.

  2. Calculate the cost of preferred stock (k(p)): The preferred stock pays a 12% annual dividend and has flotation costs of 5%. The cost of preferred stock is calculated by dividing the annual dividend by the net proceeds after flotation costs:

    Annual dividend = $100 * 12% = $12. Flotation costs = $100 * 5% = $5. Net proceeds after flotation costs = $100 - $5 = $95.

    Therefore, the cost of preferred stock (k(p)) is: k(p) = Annual dividend / Net proceeds after flotation costs = $12 / $95 = 12.63%.

  3. Calculate the cost of common equity (k(s)): The cost of common equity can be calculated using the capital asset pricing model (CAPM).

    Risk-free rate = 10% Market risk premium = 5% Rollins' beta = 1.2

    k(s) = Risk-free rate + (Beta * Market risk premium) = 10% + (1.2 * 5%) = 16%.

    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). Therefore, the adjusted cost of common equity (k(s)) is: k(s) = 10% + 4% = 14%.

  4. Calculate the weight of each component in the capital structure: Debt weight = 20% Preferred stock weight = 20% Common equity weight = 60%

  5. Calculate the retained earnings break point: Retained earnings break point = (Total assets - Total debt - Total preferred stock) * Common equity weight

    The total assets can be calculated using the bond value: Total assets = Total debt + Total preferred stock + Total common equity Total assets = $1,000 (bond value) + $100 (preferred stock value) + (Total common equity)

    We need to find the value of total common equity to calculate the retained earnings break point. To do this, we can use the

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