Here is the condensed 2008 balance sheet for Skye Computer Company (in thousands
ID: 2664832 • Letter: H
Question
Here is the condensed 2008 balance sheet for Skye Computer Company (in thousands of dollars):
2008
Current Assets $2,000 Current Liability $900
Net fixed assets $3,000 Long- term debt $1,200
Total assets $5,000 Preperred stock $250
Common stock $1,300
Retained earnings $1,350
Total common equity $2,650
Total liability & equity $5,000
Skye's earnings per share last year were $3.20, the common stock sells for $55.00, last year's 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 9% 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 $30.00 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 35%. The market risk premium is 5%, the risk-free rate is 6%, and Skye's beta is 1.516. In its cost of capital calculations, the company considers only long-term capital; hence, it disregards current liabilities.
a)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.
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 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 ?
Explanation / Answer
a.
1. Cost of debt = Kd(1- tax) = 10%(1-.35) = 6.5%
2. Cost of preferred capital = Dividend of preferred share/Price of Preferred share = $3.30/$30 = 0.11 or 11%
3. Cost of equity from retained earnings = D0(1+g)/P0 +g = $2.10(1+0.09)/$50 + 9% = 13.58%
4. Cost of common equity from new common stock = D0(1+g)/P0 (1- f )+g = $2.10(1+0.09)/$50(1- 0.10) + 9% = 14.09%
b. Cost of common equity from retained earnings using the CAPM method = Krf + (Km - Krf) Beta
= 6% + 5% * 1.516 = 13.58%
c. Cost of new common stock based on the CAPM = Cost of common equity + differential = 13.58% + 0.51% = 14.09%.
Differential = Cost of common equity from new common stock - Cost of common equity from retained earnings; 14.09% - 13.58% = 0.51%
d.
WACC using retained earnings for equity = Wd * Kd(1-Tax) + Wpf * Kpf + We *Ke
= 29.3 * 0.065 + 6.1 * 0.11 + 64.6 * 0 .1358 = 11.35%
WACC using new common stock = 29.3 * 0.065 + 6.1 * 0.11 + 64.6 * 0 .1409 = 11.68%
Skye's WACC will be 11.35% so long as it finances with debt, preferred stock, and common equity raised as retained earnings. If it expands so rapidly that it uses up all of its retained earnings and must issue new common stock with a cost of 14.09%, then its WACC will increase to 11.68%
EPS $3.2 P0 $50 Price of preferred share $30 Dividend of preferred share $3.30 D0 $2.10 g 9% Before tax Kd 10% Skye's beta 1.516 Market risk premium, kM - kRF 5% Risk free rate, kRF 6% Tax rate 35% Flotation cost for common (f) 10%