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Skye's earnings per share last year were $3.20; the common stock sells for $55, last years dividend 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 a rate of 12.5% per year. Skye's preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $31.5 per share. The firm can issue long-term debt at an interest rate (or before- tax cost) of 10%, and its marginal tax rate is 33.5%. The market risk premium is 5%, the risk-free rate is 6%, and Skye's beta is 1.55. In its cost of capital calculations, the company considers only long-term capital, hence it disregards current liabilities.

1. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of equity from retained earnings, and the cost of newly issued common stock. Use the DCF method to find the cost of common equity.

2. Now calculate the cost of common equity using retained earnings using the CAPM method.

3. 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.)

4. If Skye continues to use the same capital structure, what is the firm's WACC assuming that (1) it uses only retained earnings for equity? (2) If it expands so rapidly that it must issue new common stock?

Here is the condensed 2020 balance sheet for Skye Computer Company (in thousands of dollars): CONDENSED BALANCE SHEET FOR SKYE COMPUTER COMPANY Current assets Net fixed assets 2020 $2,000 3,000 $5,000 Total assets Current liabilities Long-term debt Preferred stock Common stock Retained earnings Total common equity Total liabilities & equity $900 1,200 250 1,300 1,350 $2,650 $5,000

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