Here is the considered 2011 balance sheet for Skye Computer Company ( in thousan

Question

Here is the considered 2011 balance sheet for Skye Computer Company ( in thousands of dollars):

Current Assets: 2000; Net Fixed Assets: 3000; Total Assets; 5000.

Current liabilities: 900; long term debt: 1200; Preferred stock(10000 shares): 250; common stock (50000 shares): 1300; retained earnings: 1350; total common equity: 2650; total liabilities and equity: 5000

Skye's earnings per share last year were $3.20. The common stock sells for $55.00, last year's dividend (Do) 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 firm can issue long term debt at an interest rate (or before-tax cost) of 10%, and its marginal tax rate is 35%. The firm's currently outstanding 10% annual coupon rate long-term debt sells at par value. 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 for calculating its WACC.

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.

Explanation / Answer

Cost of common equity from retained earnings:                            Cost of common equity(DCF) = Currnet year dividend/Market price + Growth rate                                     Current year dividend is = Last year dividend*(1+g)                                                                               = $2.10*(1+0.09)                                                                               = $2.10*(1.09)                                                                               = $2.289                               Cost of common equity = $2.289/$55 + 0.09                                                                          = 0.0416 +0.09                                                                          = 0.01316                                                                           =13.16% Cost of newly issued common stock:                               For calculating newly issued common stock, here we have to deduct the Flotation charges. Flotation charges are 10% on market price of the common stock.                         Flotation charges = 10%*$55                                                        = $5.5                   New market price is = $55 - $5.5                                                       =$49.5                   Cost of newly issued common stock = $2.289/$49.5 + 0.09                                                                                  = 0.0462 +0.09                                                                                  = 0.1362                                                                                  = 13.62% Cost of preferred stock:                         Cost of preferred stock = Preferred dividend/Market price of preferred stock                                                                   = $3.30/$30                                                                   = 0.11                                                                   = 11% Cost of debt:                       Here, cost of debt before taxes is 10%.                                  Cost of debt after taxes = Cost of debt before taxes*(1-tax rate)                                                                           = 10%*(1-0.35)                                                                           = 10%*0.65                                                                           = 6.5%                                        Therefore cost of debt after-taxes is 6.5% Calulation of WACC:                WACC = Cost of debt after-taxes*Propotion of debt + Cost of equity*propotion of equity+Cost of preferred stock*propotion of preferred stock       Market value of total debt, equity and preferred stock    = 500                      Proportion of debt = Value of debt/Total value of firm                                                       = 1200/5000                                                       = 0.24                      Proportion of equity = Value of equity/Total value of firm                                                         = 2650/5000                                                         = 0.53                   Proportion of preferred stock   = Value of preferred stock/Total value of firm                                                                         = 250/5000                                                                          = 0.05                   WACC     = 6.5%*0.24 + 13.62%*0.53+11%*0.05                                     = 1.56%+7.2186%+0.55%                                     =9.3286%

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

---