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# Rollins' WACC

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Rollins Corporation has a target capital structure consisting of 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. 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 that 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 that 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 ks. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.

1. What is Rollins' component cost of debt?

2. What is Rollins' cost of preferred stock?

3. What is Rollins' cost of retained earnings using the CAPM approach?

4. What is the firm's cost of retained earnings using the DCF approach?

5. What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

6. What is Rollins' WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget?

Viduka Construction's CFO wants to estimate the company's WACC. She has collected the following information:

? The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of \$1,000, and they currently sell for \$945.
? The company's stock has a beta = 1.20.
? The market risk premium, kM - kRF, equals 5 percent.
? The risk-free rate is 6 percent.
? The company has outstanding preferred stock that pays a \$2.00 annual dividend. The preferred stock sells for \$25 a share.
? The company's tax rate is 40 percent.
? The company's capital structure consists of 40 percent long-term debt, 40 percent common stock, and 20 percent preferred stock.

7. What is the company's after-tax cost of debt?

8. What is the company's after-tax cost of preferred stock?

9. What is the company's after-tax cost of common equity?

10. What is the company's WACC?

11. Your company is choosing between the following non-repeatable, equally risky, mutually exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How much value will your firm sacrifice if it selects the project with the higher IRR?

Project S: 0 1 2 3
| | | |
-1,000 500 500 500

Project L: 0 1 2 3 4 5
| | | | | |
-2,000 668.76 668.76 668.76 668.76 668.76

12. Green Grocers is deciding among two mutually exclusive projects. The two projects have the following cash flows:

Project A Project B
Year Cash Flow Cash Flow
0 -\$50,000 -\$30,000
1 10,000 6,000
2 15,000 12,000
3 40,000 18,000
4 20,000 12,000

The company's weighted average cost of capital is 10 percent (WACC = 10%). What is the net present value (NPV) of the project with the highest internal rate of return (IRR)?

13. Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of \$275,000 and is expected to provide after-tax annual cash flows of \$73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent. What is the project's MIRR?

14. Downingtown Industries has an overall (composite) WACC of 10 percent. This cost of capital reflects the cost of capital for a Downingtown project with average risk; however, there are large risk differences among its projects. The company estimates that low-risk projects have a cost of capital of 8 percent and high-risk projects have a cost of capital of 12 percent. The company is considering the following projects:

Project Expected Return Risk
A 15% High
B 12 Average
C 11 High
D 9 Low
E 6 Low

Which of the projects should the company select to maximize shareholder wealth?

a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.

15. In theory, the decision maker should view market risk as being of primary importance. However, within-firm, or corporate, risk is relevant to a firm's

a. Well-diversified stockholders, because it may affect debt capacity and operating income.
b. Management, because it affects job stability.
c. Creditors, because it affects the firm's credit worthiness.
d. Statements a and c are correct.
e. All of the statements above are correct.

16. Given the following information, calculate the NPV of a proposed project: Cost = \$4,000; estimated life = 3 years; initial decrease in accounts receivable = \$1,000, which must be restored at the end of the project's life; estimated salvage value = \$1,000; earnings before taxes and depreciation = \$2,000 per year; tax rate = 40 percent; and cost of capital = 18 percent. The applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent.

17. Stanton Inc. is considering the purchase of a new machine that will reduce manufacturing costs by \$5,000 annually and increase earnings before depreciation and taxes by \$6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for \$10,000 before taxes. Stanton's marginal tax rate is 40 percent, and it uses a 9 percent cost of capital to evaluate projects of this type. The applicable depreciation rates are 20 percent, 32 percent, 19 percent, 12 percent, 11 percent, and 6 percent. If the machine's cost is \$40,000, what is the project's NPV?

18. Which of the following statements is most correct?

a. When evaluating corporate projects it is important to include all sunk costs in the estimated cash flows.
b. When evaluating corporate projects it is important to include all relevant externalities in the estimated cash flows.
c. Interest expenses should be included in project cash flows.
d. Statements a and b are correct.
e. All of the statements above are correct.

19. Which of the following is not a cash flow that results from the decision to accept a project?

a. Changes in net operating working capital.
b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.
e. Externalities.

20. Which of the following is not discussed in the text as a method for analyzing risk in capital budgeting?

a. Sensitivity analysis.
b. Beta, or CAPM, analysis.
c. Monte Carlo simulation.
d. Scenario analysis.
e. All of the statements above are discussed in the text as methods for analyzing risk in capital budgeting.

#### Solution Preview

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Rollins Corporation has a target capital structure consisting of 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Assume the firm has insufficient retained earnings to fund the equity portion of its capital budget. 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 that 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 that 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 ks. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent.

1. What is Rollins' component cost of debt?

2. What is Rollins' cost of preferred stock?

3. What is Rollins' cost of retained earnings using the CAPM approach?

4. What is the firm's cost of retained earnings using the DCF approach?

5. What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

6. What is Rollins' WACC, if the firm has insufficient retained earnings to fund the equity portion of its capital budget?

Viduka Construction's CFO wants to estimate the company's WACC. She has collected the following information:

? The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face value of \$1,000, and they currently sell for \$945.
? The company's stock has a beta = 1.20.
? The market risk premium, kM - kRF, equals 5 ...

#### Solution Summary

This provides the steps to calculate the Rollins' WACC

\$2.19