Exam 12: Capital Structure

Rollins Corporation Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. 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 which 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 which 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 rs. The firm'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 firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' lowest WACC?

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

Which of the following may be true concerning debt and equity?

Each component cost of particular types of capital is identical for each source of funds found in a firm's capital structure.

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

Rollins Corporation Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. 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 which 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 which 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 rs. The firm'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 firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

Which of the following statements is correct?

The cost of debt, rd, is always less than rs, so rd(1 − T) will certainly be less than rs.Therefore, since a firm cannot be 100% debt financed, the weighted average cost of capital will always be greater than rd(1 − T).

The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock.

Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because

If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.In other words, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

A graph of a firm's acceptable capital projects ranked in the order of the projects' internal rate of return is called the firm's .

Flotation costs associated with issuing new equity cause the cost of external equity to be lower than the cost of retained earnings.

The target capital structure of a firm is the capital structure that

Tapley Inc.'s current (target) capital structure has a target debt ratio (D/TA) of 60 percent.The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.If more debt is required, the initial cost will be 8.5 percent, And if more than $10 million of debt is required, the cost will be 9 percent.Net income for the previous year was $10 million, and it is expected to increase by 10 percent this year.The firm expects to maintain its dividend payout ratio Of 40 percent on the 1 million shares of common stock outstanding.If it must sell new common stock, it would encounter a 10 percent flotation cost on the first $2 million, a 15 percent cost if more than $2 million but less than $4 million is needed, and a 20 percent cost if more than $4 million of new outside equity is required.Tapley's tax rate is 30 percent, and its current stock price is $88 per share.If the firm has an unlimited number of projects which will earn a 10.25 percent return, what is the maximum capital budget that can be adopted without adversely affecting stockholder wealth?

Which of the following statements is correct?

The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

Long-term capital gains are taxed at a lower rate than dividends for most stockholders leading companies to pay out dividends rather than use retained earnings to fund capital projects.

The correct discount rate for a firm to use in capital budgeting, assuming that new investments are of the same degree of risk as the firm's existing assets, is its marginal cost of capital.

Gulf Electric Company Gulf Electric Company (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity. Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs. GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year. GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent. All of the company's potential projects are equally risky. -Refer to Gulf Electric Company.Assume now that GEC needs to raise $300 million in new capital.What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?