Question

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Rollins' beta is 1.6 , the risk-free rate is 4 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 $30 per share, and has a growth rate of 5 percent. The firm's policy is to use a risk premium of 5 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 37 percent. What is Rollins cost of equity when using the DCF approach? Express your answer in percentage (without the % sign) and round it to two decimal places.

Answer 1

In order to use the discounted cash flow (DCF) method of calculating the cost of equity, we first identify the cash flow to the shareholders. Dividends are the only cash flow to the shareholders that accrue directly from the company.

In case of Rollins Corporation, the dividend is expected to grow at the rate of 5% each year constantly in perpeturity.

Hence we use the following formula as the base while finding the cost of equity for a constant growth firm:

where

P₀ = Current Market Price of the company's stock

D₀ = Last dividend

g = Constant growth rate of the firm

k_e = Cost of equity

Plugging in the values from the question in the formula above we get,

Transposing we get,

Hence Cost of equity using the DCF method is 12%.