Problem1. Here is the condensed 2012 balance sheet for Skye Computer Company (in term o thousand 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 previous year were $3.20. The common stock sells for $55.00, previous year's dividend (Do) was $2.10, and a flotation cost of 10% would be needed to sell new common stock. Security analysts are projecting that the common dividend will grow at 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 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%, risk free rate is 6% and Skye's beta is 1.516. In its cost of capital computation, the company considers only long-term capital; thus, it disregards current liabilities for computing its WACC.
Question1. Compute the cost of each capital component, that is, after-tax cost of debt, cost of preferred stock, the cost of equity from retained earnings and cost of newly issued common stock. Use the DCF technique to find the cost of common equity.
Question2. Now compute the cost of common equity from retained earnings using the CAPM method.
Question3. What is the cost of new common stock based on CAPM? (Hint: Find out the difference between re and rs as determined by the DCF technique and add that differential to the CAPM value for rs.)
Question4. If Skye continues to use the same market-value capital structure, what is firm's WACC supposing that (1) it uses only retained earnings for equity? (2) If it expands so rapidly that is should issue new common stock?