Question

Rollins Corporation is estimating its WACC. 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 rs. The firm's marginal tax rate is 40 percent.

First step What is Rollins' component cost of debt?

Second step What is Rollins' cost of preferred stock?

third step What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?

Fourth step What is the firm's cost of common stock (rs) using the DCF approach?

fifth step What is Rollins' cost of common stock (rs) using the CAPM approach?

Last step What is Rollins' WACC.

Please answer the steps for this question and show me how you got them thanks.

Answer 1

a) Rollins cost of debt = Coupon rate if the Bond is sold at par at 1000 = 12%

b)Dividend = 12% * Par value = 12% * 100 = 12
Cost of Preferred St0ck = dividend/(Par Value *(1- flotation cost) + Growth = 12/(100 *(1-5%)) + 0 = 12.63%

c) Cost of equity using Bond Plus risk premium = 12% + 4% =16%

d) Cost of equity using DCF = Dividend /Price of Share + Growth = 2/27 + 8% = 15.41%

e) Cost of Equity CAPM = Risk Free rate + Beta *(Market risk Premium) = 10% + 1.2 * 5% = 16%

f)Using copst of Equity as 16% as CAPM method is better
WACC = Weight of debt * Cost of Debt ( 1- tax rate) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Equity * Cost of equity = 20% * 12%*(1-40%) + 20% * 12.63% + 60% * 16% =13.57%