Here is the condensed 2012 balance sheet for Skye Computer Company (in thousands of dollars):
End of 2012
Current assets $2,000
Net fixed assets $3,000
Total assets $5,000
Current liabilities $900
Long-term debt $1,200
Preferred stock (10K shares) $250
Common stock (50K Shares) $1,300
Retained earnings $1,350
Total common equity $2,650
Total liabilities & equity $5,000
Skye's earnings per share last year were $3.20. The common stock sells for $55.00, last year’s dividend D0) 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 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 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