Chapter 10. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem 4 Probl

Question

Chapter 10. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem 4 Problem 10-21 6 Here is the condensed 2018 balance sheet for Skye Computer Company (in thousands of dollars): 7 8 CONDENSED BALANCE SHEET FOR SKYE COMPUTER COMPANY 9 10 BV Capital Structure % incl. CL % excl. CL MV Capital Structure Dollars % excl. CL 2018 $2,000 3,000 $5,000 12 Current assets 13 Net fixed assets 14 Total assets 15 16 Accounts pavable and accruals 17 Short-term debt 18 Long-term debt 19 Total debt 20 Preferred stock 21 Common stock 22 Retained earnings 23 Total common equity 24 Total liabilities & equity 25 26 Skye's earnings per share last year were S3.20. The common stock sells for $55.00, last year's dividend (Do) was $2.10 27 and a flotation cost of 10% would be required to sell new common stock. Security analysts are projecting that the common 28 dividend will grow at an annual rate of 9%. Skye's preferred stock pays a dividend of $3.30 per share, and its preferred 29 stock sells for S30 per share. The firm's before-tax cost of debt is 10%, and its marginal tax rate is 35%. The firm's 30 currently outstanding 1000 annual coupon rate, long-term debt sells at par value. The market risk premium is 5% 31 the risk-free rate is 6%, and Skye's beta is 1.516. The firm's total debt, which is the sum of the company's short-term 32 debt and long-term debt, equals $1.2 million 18.0% $900 100 1,100 $1,200 250 1,300 1,350 $2,650 $5,000 24.0% 5.0% 29.3% 6.1% $1,200 300 28.2% 7.1% 53.0% 100.0% 64.6% 100.0% 2.750 S4,250 64.7% 100.0% 34 a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock, the cost of 35 equity from retained earnings, and the cost of newly issued common stock. Use the DCF method to find the cost of 36 common equi 37

Explanation / Answer

a) After tax cost of Debt = Before tax cost of debt x (1 - tax rate) Before Tax cost of Debt 10.00% Tax rate 35.00% After tax cost of Debt =10% x (1-35%) 6.50% Cost of preferred Stock = Dividend per share/ Price Preferred dividend per share $3.3 Preferred stock current price $30 Cost of preferred Stock 11.00% Cost of equity from retained earnings Dividend Paid (D0) $2.1 Current Price $55 Growth rate 9.00% Cost of equity from retained earnings = D0 x (1+ G)/Price + Growth Cost of Equity = ($2.10 x (1+9%)/$55) + 9% 13.16% Cost of equity from new common stock Dividend Paid (D0) $2.1 Current Price $55 Growth rate 9.00% Floatation Cost 10.00% Cost of equity from common stock= D0 x (1+ G)/Price x (1-f)+ Growth Cost of Equity = ($2.10 x (1+9%)/$49.5) + 9% 13.62% b) CAPM Risk free Rate (RF) 6.00% Market Risk Premium(MRP) 5.00% Beta 1.516 Cost of equity = Rf + beta x MRP Cost of equity = 6% + 1.516 x 5% 13.58% C. Cost of equity of new common stock = 13.58% + (13.62% -13.16%) 14.04% d. Cost of equity = Average(13.16%,13.58%) 13.37% WACC using Retained Earnings Weights Cost of capital Weights x cost of capital Common equity 64.70% 13.37% 8.65% Preferred 7.10% 11.00% 0.78% Debt 28.20% 6.50% 1.83% WACC using Retained Earnings 100.00% 11.26% Cost of equity = Average(14.04%,13.58%) 13.58% WACC using new common equity Weights Cost of capital Weights x cost of capital Common equity 64.70% 13.83% 8.95% Preferred 7.10% 11.00% 0.78% Debt 28.20% 6.50% 1.83% WACC 100.00% 11.56%

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