Problem 4 Skye Inc\'s the common stock sells for $55, last year\'s dividend was
ID: 2796814 • Letter: P
Question
Problem 4 Skye Inc's the common stock sells for $55, last year's dividend was $2.10. Security analysts are projecting that the common dividend will grow at a rate of g% per year. 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 expected return on market is 11%, the risk-free rate is 6%, and Skye's beta is 1.516. Skye has 30% debt, and 70% equity in the capital structure a) Calculate the cost of each capital component, that is, the after-tax cost of debt, and the cost of equity. b) If Skye continues to use the same capital structure, what is the firm's WACC?Explanation / Answer
This is the problem to determine Firm's WACC i.e. Weighted Average Cost of Capital.
There are two components of WACC i.e. Weighted Average Cost of Debt and Weighted Average Cost of Equity,
By use of standardized set of formulae, we can compute the WACC for firm.
Skye Inc Firm can issue long term debt at pre tax cost of 10%. Marginal Tax rate is 35%
Cost of Debt = Interest rate on long term debt * (1-marginal tax rate)
= 10%(1-0.35)= 6.5%
2. To determine cost of Equity
Formula for Cost of Equity = Risk Free Rate + Beta(Market Rate of Return-Risk Free Return)
Risk Free Rate is 6%, Beta is 1.516 and market expected return is 11%
Cost of Equity = 6 %+ 1.516(11%-6%) = 13.58%
Answer For a)
Cost of Debt is 6.5% and Cost of Equity is 13.58%.
b) Sky has 30% debt and 70% equity in the capital structure.
WACC = weight of Debt in Capital Structure * Cost of Debt + weight of Equity in Capital Structure * Cost of Equity
= 0.30*6.5 + 0.70*13.58 = 1.95+9.5060 = 11.456%
WACC of Sky Inc is 11.456%
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