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

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Finance

Here is the condensed 2015 balance sheet for Skye ComputerCompany (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’sshort-term debt and long-term debt, equals $1.2 million. The firm’sbefore-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 stocksells 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 tosell new common stock. Security analysts are projecting that thecommon dividend will grow at an annual rate of 9%. Skye’s preferredstock pays a dividend of $3.30 per share, and its preferred stocksells for $30.00 per share. The outstanding common stock shares is50,000 and outstanding preferred stock shares is 10,000. The marketrisk premium is 5%, the risk-free rate is 6%, and Skye’s beta is1.516
a. Calculate the cost of each capital component, that is, theafter-tax cost of debt
(rd(1 – T)), the cost of preferred stock (rp), the cost ofequity from retained earnings (rs),
and the cost of newly issued common stock(re). Use theDiscounted 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 retainedearnings, 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 andadd that differential to
the CAPM value for rs.)
d. If Skye continues to use the same market-value capitalstructure, (1) what is
the firm’s WACC assuming that it uses only retained earnings forequity? (2) what is the
firm’s WACC assuming that if it expands so rapidly that it mustissue new common
stock? (Hint: use current value of stocks to obtain themarket-value capital structure, the
weights of capital.)

Answer & Explanation Solved by verified expert

3.7 Ratings (311 Votes)

a After tax cost of debt rd1t 10135 650 Cost of preferred stock 33030 1100 Cost of retained earnings rs 21010955009 1316 Cost of newly issued common stock re 2101095590009 1362 b Cost of retained earnings rs per CAPM 615165 1358 c Cost of new common stock per CAPM 135813621316 1404 d As nothing is said about the method for cost of equity to be used for WACC the WACC has been has been See Answer

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Transcribed Image Text

Here is the condensed 2015 balance sheet for Skye ComputerCompany (in thousands of dollars):2015Current assets $2,000Net fixed assets 3,000Total assets $5,000Accounts payable and accruals $900Short-term debt 100Long-term debt 1,100Total debt $1,200Preferred stock 250Common stock 1,300Retained earnings 1,350Total common equity $2,650Total liabilities & equity $5,000The firm’s total debt, which is the sum of the company’sshort-term debt and long-term debt, equals $1.2 million. The firm’sbefore-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 stocksells 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 tosell new common stock. Security analysts are projecting that thecommon dividend will grow at an annual rate of 9%. Skye’s preferredstock pays a dividend of $3.30 per share, and its preferred stocksells for $30.00 per share. The outstanding common stock shares is50,000 and outstanding preferred stock shares is 10,000. The marketrisk premium is 5%, the risk-free rate is 6%, and Skye’s beta is1.516a. Calculate the cost of each capital component, that is, theafter-tax cost of debt(rd(1 – T)), the cost of preferred stock (rp), the cost ofequity from retained earnings (rs),and the cost of newly issued common stock(re). Use theDiscounted 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 retainedearnings, using theCAPM method.C. What is the cost of new common stock based on the CAPM?(Hint: Find thedifference between re and rs as determined by the DCF method andadd that differential tothe CAPM value for rs.)d. If Skye continues to use the same market-value capitalstructure, (1) what isthe firm’s WACC assuming that it uses only retained earnings forequity? (2) what is thefirm’s WACC assuming that if it expands so rapidly that it mustissue new commonstock? (Hint: use current value of stocks to obtain themarket-value capital structure, theweights of capital.)