Debt: The firm currently has bonds outstanding that have the following characteristics:
maturity value = $1,000, coupon rate of interest = 14%, years to maturity (n) = 15, and interest is paid annually. The market value of the bond is $1,304.24.
Preferred Stock: The firm just issued preferred stock at a par value of $50. The shares pay a dividend of $4.50 per year.
Equity: Rollins was initially financed by selling 2 million shares of common stock at $12. Accumulated retained earnings are now $5 million. The stock is currently selling at $13.25.
Rollins’ Target Capital Structure is as follows:
Preferred Stock 5.0%
Common Equity 65.0%
· Rollins’ marginal tax rate (state and federal) is 40% (i.e. T = 40%).
· Flotation costs average 12% for common and preferred stock (i.e. F = 12%).
· Short-term treasury bills currently yield 7.5% (i.e. rRF = 7.5%).
· The market is returning 12.5% (i.e. rM = 12.5%).
· Rollins’ beta is 1.2 (i.e. β = 1.2).
· The risk premium = 4% for the bond-plus-risk-premium approach (i.e. RP = 4%).
· The firm is expected to grow at 6% indefinitely (i.e. g = 6%).
· The last annual dividend paid was $1.00 per share (i.e. D0 = $1.00).
· Rollins expects to add $2.7 million to retained earnings next year.
· The firm can borrow an additional $2 million at rates similar to the market return on its current debt. Beyond that lenders are expected to demand returns of 14%.
· Rollins has the following capital budgeting projects under consideration in the coming year. These represent its investment opportunity schedule (IOS).
Project IRR Required
A 15.0% $3M
B 14.0% $5M
C 13.0% $7M
D 12.0% $9M
E 11.0% $11M
a. Calculate the component cost of debt based on the market return on the company's existing bonds.
b. Calculate the component cost of preferred stock based on the market return on the company’s existing preferred stock.
c. Calculate the component cost of retained earnings using three approaches, CAPM, dividend growth, and risk premium. Reconcile the results into a single estimate.
d. Calculate the component cost of new common equity.
e. Calculate the WACC using the component costs of debt, preferred stock, retained earnings, and new equity just calculated in parts a. – d.
f. Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to the nearest $0.1 million.
g. Calculate the WACC after this first breakpoint.
h. Where is the second breakpoint in the MCC (the point at which the cost of debt increases)? Calculate to the nearest $0.1 million.
i. Calculate the WACC after the second breakpoint.
If you wish to, you may plot Rollins’ MCC and IOS schedule to help with the next question.
j. Which projects should be accepted and which should be rejected?
|Due By (Pacific Time)||08/08/2014 12:00 pm|
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