Question

Rollins Corporation is estimating its WACC.  Its only bond issue has a 6.07 percent annual yield to maturity, par value of $1,000, mature in 20 years, and has a 5.2% coupon paid semiannually (2.6%).  There is $100 million total par value of debt outstanding.  The firm currently has a $100 par preferred stock that pays a 7.5 percent annual dividend and currently yields 6 percent.  Flotation costs of 5 percent must be incurred on any new issue of preferred.  Current outstanding preferred stock has a total book value of $8 million.  Rollins' beta is 1.25, the risk-free rate is 4.5 percent, and the market risk premium is 6 percent. Rollins is a constant-growth firm that just paid a dividend of $0.47 last year.  Its common stock sells for $10.00 per share, has a dividend growth rate of 7 percent, and there are 10 million shares outstanding.  The CFO estimates that internally generated cash will be sufficient to supply additional equity funding.  The firm's policy is to use a risk premium of 6 percentage points when using the bond-yield-plus-risk-premium method to find r_s.  The firm's marginal tax rate is 40 percent.  Please show all work and place answers in the space provided.  If you get stuck on an answer, assume a number, tell me, and continue onward to receive credit on other answers.

1. What is Rollins' cost of debt?____________

2. What is Rollins' cost of preferred stock?________

3. What is Rollins' cost of common stock (r_s) using the CAPM approach?_______

4. What is the firm's cost of common stock (r_s) using the DCF approach?_______

5. What is Rollins' cost of common stock using the bond-yield-plus-risk-premium approach?_______

6. Given your answers to the three previous questions, provide and explain your estimate of the cost of equity?________

7. What are the appropriate weights for debt, preferred stock, and common stock?

            Debt weight                           _______

            Preferred stock weight         _______

            Common equity weight        _______

8. What is Rollins' WACC?_______

Answer 1

The yield of debt  is 6.07% and the rate of interest  is 5.2 %

That means debt is issued at discount of 14.33% ( 1 - (.052 / .0607)

Cost of Debt = [Interest Rate * ( 1 - tax Rate)] / (1-0.1433

Cost of Debt = [.052 * ( 1 - 0.40)] / 0.8567 = 3.64%

.

The yield of preference stock is 6% and the rate of dividend is 7.5%

That means the preference stock are issued at premium of 25% (.075 / .06 - 1)

Cost of Preferred Stock = Dividend % / Issue Price * (1 - Cost of Issue)

Cost of Preferred Stock = 0.075 / 1.25 ( 1-0.05) = 0.06315 or 6.315%

Cost of Common Stock = Rf + Beta * (Market Risk Premium)

Cost of Common Stock = 0.045 + ( 1.25 * .06)

Cost of Common Stock = 12%