Question

Here is the condensed 2015 balance sheet for Skye Computer Company (in thousands of dollars):

2015

Current assets $2,000

Net fixed assets 3,000

Total assets $5,000

Accounts payable and accruals $900

Short-term debt 100

Long-term debt 1,100

Total debt $1,200

Preferred stock 250

Common stock 1,300

Retained earnings 1,350

Total common equity $2,650

Total liabilities & equity $5,000

The firm’s total debt, which is the sum of the company’s short-term debt and long-term debt, equals $1.2 million. The firm’s before-tax cost of debt is 10%, and its marginal tax rate is 35%. Skye’s earnings per share last year were $3.20. The common stock sells for $55.00 now in the secondary market, last year’s dividend (D0) was $2.10, and a flotation cost of 10% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 9%. Skye’s preferred stock pays a dividend of $3.30 per share, and its preferred stock sells for $30.00 per share. The outstanding common stock shares is 50,000 and outstanding preferred stock shares is 10,000. The market risk premium is 5%, the risk-free rate is 6%, and Skye’s beta is 1.516

a. Calculate the cost of each capital component, that is, the after-tax cost of debt

(rd(1 – T)), the cost of preferred stock (rp), the cost of equity from retained earnings (rs),

and the cost of newly issued common stock(re). Use the Discounted Cash Flow (DCF)

method to find the cost of common equity, e.g. rs and re.

b. Now calculate the cost of common equity from retained earnings, using the

CAPM method.

C. What is the cost of new common stock based on the CAPM? (Hint: Find the

difference between re and rs as determined by the DCF method and add that differential to

the CAPM value for rs.)

d. If Skye continues to use the same market-value capital structure, (1) what is

the firm’s WACC assuming that it uses only retained earnings for equity? (2) what is the

firm’s WACC assuming that if it expands so rapidly that it must issue new common

stock? (Hint: use current value of stocks to obtain the market-value capital structure, the

weights of capital.)

Answer 1

a)	After tax cost of debt [rd*(1-t)] = 10%*(1-35%) =	6.50%
	Cost of preferred stock = 3.30/30 =	11.00%
	Cost of retained earnings [rs] =2.10*1.09/55+0.09 =	13.16%
	Cost of newly issued common stock [re] =2.10*1.09/(55*90%)+0.09 =	13.62%
b)	Cost of retained earnings [rs] per CAPM = 6%+1.516*5% =	13.58%
c)	Cost of new common stock per CAPM = 13.58%+(13.62%-13.16%) =	14.04%
d)	As nothing is said about the method for cost of equity to be used for WACC, the WACC has been
	has been calculated using cost of retained earnings and equity at DDM values, CAPM values and
	the average of DDM and CAPM values.
1)	WACC with retained earnings (using DDM for rs)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	13.16%	8.52%
		4250000		WACC	11.13%
2)	WACC with new common equity (using DDM for re)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	13.62%	8.82%
		4250000		WACC	11.43%
1)	WACC with retained earnings (using CAPM for rs)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	Market Value	13.58%
		4250000		WACC	16.19%
2)	WACC with new common equity (using CAPM for re)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	14.04%	9.08%
		4250000		WACC	11.70%
1)	WACC with retained earnings (using average of DDM and CAPM for rs)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	13.37%	8.65%
		4250000		WACC	11.26%
2)	WACC with new common equity (using average of DDM and CAPM for re)
	Component	Market Value	Weight	Component Cost	WACC
	Debt	1200000	28.24%	6.50%	1.84%
	Preferred stock (30*10000)	300000	7.06%	11.00%	0.78%
	Retained earnings (50000*55)	2750000	64.71%	13.83%	8.95%
		4250000		WACC	11.56%