Here is the condensed 2021 balance sheet for Skye Computer Company (in thousands of dollars):
| 2021 |
Current assets | | $ | 2,000 | |
Net fixed assets | | | 3,000 | |
Total assets | | $ | 5,000 | |
|
Accounts payable and accruals | | $ | 900 | |
Short-term debt | | | 200 | |
Long-term debt | | | 1,725 | |
Preferred stock (15,000 shares) | | | 475 | |
Common stock (40,000 shares) | | | 825 | |
Retained earnings | | | 875 | |
Total common equity | | $ | 1,700 | |
Total liabilities and equity | | $ | 5,000 | |
Skye's earnings per share last year were $4.10. The common stock sells for $45.00, last year's dividend (D0) was $3.30, and a flotation cost of 9% would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at an annual rate of 8%. Skye's preferred stock pays a dividend of $4.20 per share, and its preferred stock sells for $35.00 per share. The firm's before-tax cost of debt is 12%, and its marginal tax rate is 25%. The firm's currently outstanding 12% annual coupon rate, long-term debt sells at par value. The market risk premium is 6%, the risk-free rate is 7%, and Skye's beta is 1.674. The firm's total debt, which is the sum of the company's short-term debt and long-term debt, equals $1.925 million.
The data has been collected in the Microsoft Excel file below. Download the spreadsheet and perform the required analysis to answer the questions below. Do not round intermediate calculations. Round your answers to two decimal places.
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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.
After-tax cost of debt:
Cost of preferred stock:
Cost of retained earnings:
Cost of new common stock:
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Now calculate the cost of common equity from retained earnings, using the CAPM method.
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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.)
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If Skye continues to use the same market-value capital structure, what is the firm's WACC assuming that (1) it uses only retained earnings for equity and (2) if it expands so rapidly that it must issue new common stock? (Hint: Use the market value capital structure excluding current liabilities to determine the weights. Also, use the simple average of the required values obtained under the two methods in calculating WACC.)
WACC1:
WACC2:
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Calculating the WACC Skye Computer Company: Balance Sheet as of December 31 (in thousands of dollars) 2021 Current assets Net fixed assets 3,000 3 Total assets $5,000 $2,000 0 Accounts payable and accruals $900 1 Short-term debt 200 2 Long-term debt 1,725 3 Preferred stock 475 4 Common stock 825 5 Retained earnings 875 6 Total common equity $1,700 7 Total liabilities and equity $5,000 8 9 Last year's earnings per share $4.10 o Current price of common stock, P. $45.00 1 Last year's dividend on common stock, D. $3.30 2 Growth rate of common dividend, 9 8% 3 Flotation cost for common stock, F 9% 4 Common stock outstanding 40,000 5 Current price of preferred stock, P. $35.00 6 Dividend on preferred stock, D. $4.20 7 Preferred stock outstanding 15,000 8 Before-tax cost of debt, ra 12% 9 Market risk premium, rm - IRF 6% 0 Risk-free rate, le 7% 1 Beta 1.674 2 Tax rate 25% 3 Total debt $1,925 thousand 4 5 a. Calculating the cost of each capital component (using the DCF method to find 6 the cost of common equity) 7 After-tax cost of debt 8 Cost of preferred stock 9 Cost of retained earnings 0 Cost of new common stock 1 2 b. Calculating the cost of common equity from retained earnings, using the CAPM method 3 Cost of retained earnings Al Formulas #N/A #N/A #N/A #N/A #N/A TRF 25% Formulas #N/A #N/A #N/A #N/A #N/A 0 Risk-free rate, IRF 7% 1 Beta 1.674 2 Tax rate 3 Total debt $1,925 thousand 4 5 a. Calculating the cost of each capital component (using the DCF method to find 6 the cost of common equity) 7 After-tax cost of debt 8 Cost of preferred stock 9 Cost of retained earnings 0 Cost of new common stock 1 1 2 b. Calculating the cost of common equity from retained earnings, using the CAPM method 3 Cost of retained earnings 4 c. Calculating the cost of new common stock based on the CAPM 6 Flotation cost adjustment 7 Cost of new common stock 8 9 d. Calculating the firm's WACC assuming that (1) it uses only retained earnings for equity and 0 (2) if it expands so rapidly that it must issue new common stock Market value 1 (in thousands) Weight 2 Total debt 3 Preferred stock 4 Common equity 5 Total 6 #N/A #N/A Market value (in thousands) #N/A #N/A #N/A #N/A Weight #N/A #N/A #N/A #N/A 7 WACC; #N/A #N/A 8 WACC 9 0 1 1 2 3 Calculating the WACC Skye Computer Company: Balance Sheet as of December 31 (in thousands of dollars) 2021 Current assets Net fixed assets 3,000 3 Total assets $5,000 $2,000 0 Accounts payable and accruals $900 1 Short-term debt 200 2 Long-term debt 1,725 3 Preferred stock 475 4 Common stock 825 5 Retained earnings 875 6 Total common equity $1,700 7 Total liabilities and equity $5,000 8 9 Last year's earnings per share $4.10 o Current price of common stock, P. $45.00 1 Last year's dividend on common stock, D. $3.30 2 Growth rate of common dividend, 9 8% 3 Flotation cost for common stock, F 9% 4 Common stock outstanding 40,000 5 Current price of preferred stock, P. $35.00 6 Dividend on preferred stock, D. $4.20 7 Preferred stock outstanding 15,000 8 Before-tax cost of debt, ra 12% 9 Market risk premium, rm - IRF 6% 0 Risk-free rate, le 7% 1 Beta 1.674 2 Tax rate 25% 3 Total debt $1,925 thousand 4 5 a. Calculating the cost of each capital component (using the DCF method to find 6 the cost of common equity) 7 After-tax cost of debt 8 Cost of preferred stock 9 Cost of retained earnings 0 Cost of new common stock 1 2 b. Calculating the cost of common equity from retained earnings, using the CAPM method 3 Cost of retained earnings Al Formulas #N/A #N/A #N/A #N/A #N/A TRF 25% Formulas #N/A #N/A #N/A #N/A #N/A 0 Risk-free rate, IRF 7% 1 Beta 1.674 2 Tax rate 3 Total debt $1,925 thousand 4 5 a. Calculating the cost of each capital component (using the DCF method to find 6 the cost of common equity) 7 After-tax cost of debt 8 Cost of preferred stock 9 Cost of retained earnings 0 Cost of new common stock 1 1 2 b. Calculating the cost of common equity from retained earnings, using the CAPM method 3 Cost of retained earnings 4 c. Calculating the cost of new common stock based on the CAPM 6 Flotation cost adjustment 7 Cost of new common stock 8 9 d. Calculating the firm's WACC assuming that (1) it uses only retained earnings for equity and 0 (2) if it expands so rapidly that it must issue new common stock Market value 1 (in thousands) Weight 2 Total debt 3 Preferred stock 4 Common equity 5 Total 6 #N/A #N/A Market value (in thousands) #N/A #N/A #N/A #N/A Weight #N/A #N/A #N/A #N/A 7 WACC; #N/A #N/A 8 WACC 9 0 1 1 2 3