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' WACC once it starts using new common stock financing?
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A. B. C. D. E.C
k(e) = $2.16/ $27.00(1-.10) + 0.08 = 0.08889 + 0.08 = 0.169 = 16.9%.
WACC = 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.9%) = 14.1%.
To calculate Rollins Corporation's weighted average cost of capital (WACC), we need to determine the cost of each component of its capital structure and weight them based on their respective proportions.
Let's calculate the cost of each component:
Cost of Debt (kd): Rollins Corporation's bonds have a 12% coupon rate, paid semiannually, and a current maturity of 20 years. The bonds sell for $1,000. The formula to calculate the cost of debt is: kd = (Coupon Payment / Bond Price) + Yield to Maturity Coupon Payment = 12% * $1,000 = $120 (annual coupon payment) Bond Price = $1,000 Yield to Maturity is not provided, so we'll need to make an assumption. Let's assume a yield to maturity of 10%. kd = ($120 / $1,000) + 0.10 = 0.12 + 0.10 = 0.22 or 22%
Cost of Preferred Stock (kp): Rollins Corporation can sell preferred stock at par value, which is $100 per share, but flotation costs of 5% would be incurred. The formula to calculate the cost of preferred stock is: kp = Preferred Dividend / Net Proceeds per Share Preferred Dividend = 12% * $100 = $12 (annual preferred dividend) Net Proceeds per Share = Par Value - Flotation Costs = $100 - ($100 * 0.05) = $95 kp = $12 / $95 = 0.1263 or 12.63%
Cost of Common Equity (ke): Rollins Corporation's beta is given as 1.2, the risk-free rate is 10%, and the market risk premium is 5%. The formula to calculate the cost of common equity using the Capital Asset Pricing Model (CAPM) is: ke = Risk-Free Rate + Beta * Market Risk Premium ke = 0.10 + 1.2 * 0.05 = 0.10 + 0.06 = 0.16 or 16%
Now, let's calculate the weights of each component:
Debt Weight = 20% Preferred Stock Weight = 20% Common Equity Weight = 60%
Finally, we can calculate the WACC using the formula:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Preferred Stock * Cost of Preferred Stock) + (Weight of Common Equity * Cost of Common Equity)
WACC = (0.2 * 0.22) + (0.2 * 0.1263) + (0.6 * 0.16) = 0.044 + 0.02526 + 0.096 = 0.16526 or 16.526%
Rounded to the nearest tenth, Rollins Corporation's WACC, once it starts using new common stock financing, is approximately 16.6%.
Therefore, the correct answer is A. 16.6%.