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Calculate the cost of common equity from retained earnings

Problem:

Here is the condensed balance sheet for Skye Computer Company (in thousands of dollars):

Current Assets $2000

Net Fixed Assets $3,000

Total Assets $5,000

Current Liabilities $900

Long-Term Debt $1,200

Preferred Stock $250

Common Stock $1,300

Retained Earnings $1,350

Total Common Equity $2,650

Total Liabilities and Equity $5,000

Skye Computer's earnings per share last year were $3.20; the stock sells for $55, and last year's dividend was $2.10. A flotation cost of 10 percent would be required to issue new common stock. Skye's preferred stock pays a dividend of $3.30 per share, and new preferred stock could be sold at a price to net the company $30 per share. Security analysts are projecting that the common dividend will grow at a rate of 9 percent per year. The firm can issue additional long-term debt at an interest rate (before-tax cost) of 10%, and its marginal tax rate is 35%. 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 that purpose.

Q1. 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.

Q2. Now calculate the cost of common equity from retained earnings using the CAPM method.

Q3. What is the cost of new common stock, based on CAPM? (Hint: Find the difference between Ke and Ks as determined by the DCF method, and add that differential to the CAPM value for Ks.)

Q4. If Skye Computer continues to use the same capital structure, what is the firm's WACC assuming (1) that it uses only retained earnings for equity and (2) that it expands so rapidly that it must issue new common stock?

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