Use the following information to answer 1-6. Rollins Corporation is examining its cost of capital. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 10 percent coupon, paid semiannually, a current maturity of 20 years, a par value of $1,000, and sell for $849.54. The firm could sell at par, $100 preferred stock, which pays a 12 percent annual dividend, but floatation cost of 5 percent would be incurred. Rollinsâ€™ beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins just paid a dividend of $2.00, sells for $27.00 per share, and has a constant growth rate of 8 percent. The firmsâ€™ policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find Ra. The firmâ€™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 firmâ€™s marginal tax rate is 40 percent.
1. What is Rollinsâ€™ before-tax cost of debt?
a) 6% b) 8% c) 10% d)12% e)20%
2. What is the firms cost of preferred stock?
a) 12% b) 12.63% c) 13% d) 14.21% e) 15.48%
3. What is Rollinsâ€™ cost of retained earnings using the CAPM approach?
a) 14% b) 15% c) 16% d) 17% e)18%
4. What is firmsâ€™ cost of retained earnings using the DCF approach?
a) 16% b)15.82% c) 15.41% d) 15% e) 14.87%
5. What is firmsâ€™ cost of retained earnings using the bond-yield-plus-risk-premium approach?
a) 12% b) 13% c) 14% d) 15% e) 16%
6. Estimate Rollinsâ€™ RACC when retained earnings are used as the equity component.
a) 12.23% b) 12.56% c) 13.21% d) 13.34% e) 13.57%
Use the following information to answer 7-9. Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon has a capital structure that consists of 20 percent debt and 80 percent equity. The risk-free rate is 6 percent and the market risk premium is 5 percent. Currently, the companyâ€™s cost of equity is 12 percent and its tax rate is 40 percent.
7. What is the unlevered cost of equity?
a) 11.22% b) 11.44% c) 11.66% d) 11.88% e) 12%
8. What is the levered beta if the company were to change its capital structure to 50 percent debt and 50 percent equity?
a) 1.2 b) 1.45 c) 1.54 d) 1.67 e) 1.81
9. What would be Simonâ€™s levered cost of equity with the new capital structure (50 percent debt and 50 percent equity)?
a) 12% b) 13.41 c) 14.35 d) 15.24 e) 16%
Use the following information to answer 10-11. The A.J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000 and it is a zero-growth company. AJCâ€™s cost of equity is 10 percent, and the tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding. (10 points)
10. What is AJCâ€™s current total market value?
a) $728,000 b) $628,000 c) $528,000 d) $428,000 e) $328,000
11. What is AJCâ€™s current stock price?
a) $32.8 b) $42.8 c) $52.8 d) $62.8 e) $72.8
Use the following information to answer 12-14. The Hatfield Corporation is a zero growth firm with an expected EBIT of $250,000 and a corporate tax rate of 40 percent. Hatfield uses $1 million of debt financing, and the cost of equity to an unlevered firm in the same risk class is 15.0 percent. The personal tax rates of Hatfieldâ€™s investors are 30 percent on debt (interest) income and 20 percent (on average) on income from stocks.
11. What is the value of the firm according to MM with corporate taxes?
a) $1m b) $1.2m c) $1.4m d) $1.6m e)$2m
12. What is the firmâ€™s cost of equity if its debt cost is 10.0 percent?
a) 24% b) 22.5% c)20% d) 18% e) 15%
13. What is the firmâ€™s value according to the Miller model? (Hint: donâ€™t forget that the addition of personal taxes lowers the value of the unlevered firm.)
a) $0.8m b) $1m c) $1.1m d) $1.2m e) $1.3m