Current assets $2,000

Net fixed assets 3,000

Total assets $5,000

Current liabilities $ 900

Long-term debt 1,200

Preferred stock (10,000 shares) 250

Common stock (50,000 shares) 1,300

Retained earnings 1,350

Total common equity $2,650

Total liabilities and equity $5,000

Skye’s earnings per share last year were $3.20. The common stock sells for $55.00, last year’s dividend (D) 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.

a. Calculate the cost of each 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 earning 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 market value 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?