Take-home Exercise 5

Skye's earnings per share last year were $3.20; the common stock sells for $55, last year’s
dividend 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 a rate of 11% per year.
Skye's preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a
price to net the company $32 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 33%. The market risk premium is 5%, the
risk-free rate is 6%, and Skye's beta is 1.416. In its cost of capital calculations, the company
considers only long-term capital, hence it disregards current liabilities.
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.
- T = 33% Before-tax cost of debt = 10%
The after-tax cost of debt = Before-tax cost of debt * (1 – T) = 6.7%
- 𝐷𝑃 = $3.30 𝑃𝑃 = 32%

𝐷𝑃
The cost of preferred stock = 𝑟𝑃 = 𝑃𝑃
= 10.31%

- 𝐷0 = $2.10 𝑃0 = $55 g = 11%

𝐷0 *(1 + 𝑔)
The cost of equity from retained earnings = 𝑟𝑠 = 𝑃0
+ 𝑔 = 15.24%

- F = 10%
𝐷0 * (1 + 𝑔)
The cost of newly issued common stock (DCF method) = 𝑟𝑒 = 𝑃0* (1−𝐹)
+ 𝑔 = 15.71%

b. Now calculate the cost of common equity using from retained earnings using the CAPM
method.
𝑟𝑅𝐹 = 6% β𝑠 = 1.416 Market risk premium = 𝑟𝑀 − 𝑟𝑅𝐹 = 5%

The cost of retained earnings (CAPM method) = 𝑟𝑠 = 𝑟𝑅𝐹 + β𝑠 * Market risk premium = 13.08%

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.)
The cost of new common stock based on the CAPM = 𝑟𝑠 + (𝑟𝑒 - 𝑟𝑠 ) = 13.55%
𝑏 𝑎 𝑎

d. If Skye continues to use the same 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?
 1) First, we calculate Value of Firm for the Weight of Debt, Prefered Stock, and Common
Equity: 

Value of firm = Total Asset - Current Liabilities = $5,000 - $900 = $4,100 

Then, we are able to compute the Weights by dividing values of each by Value of Firm: 

𝐷𝑒𝑏𝑡 $1,200
WB = 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒
= $4,100
= 0.293= 29.3%

𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 $250

WP = 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒
= $4,100 = 0.061= 6.1%

𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 $2,650

WC = 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒
= $4,100
= 0.646= 64.6%

Capital Market Value ( thousands of dollars) Weight

DEBT 1,200 29.3%

PREFERRED STOCKS 250 6.1%

RETAINED EARNINGS 1,350

COMMON STOCKS 1,300

=> COMMON EQUITY 2,650 64.6%

TOTAL VALUE 4,100

15.71% + 13.55%
2) 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑤𝑖𝑡ℎ 𝑛𝑒𝑤𝑙𝑦 𝑖𝑠𝑠𝑢𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 = 2
= 14. 63%
𝑅𝑊𝐴𝐶𝐶 = 𝑊𝐵 × 𝑅𝐵 × 1 − 𝑇𝑐 ( ) + 𝑊𝑆 × 𝑅𝐸 + 𝑊𝑃 × 𝑅𝑃

= 29. 3% × 6. 7% × (1 − 33%) + 64. 6% × 14. 63% + 6. 1% × 10. 31% = 11. 4%

⇒ Skye's WACC assuming that it must issue new common stock is 11.4%