Fundamentals Of Financial Management, Concise Edition (mindtap Course List)
Fundamentals Of Financial Management, Concise Edition (mindtap Course List)
10th Edition
ISBN: 9781337902571
Author: Eugene F. Brigham, Joel F. Houston
Publisher: Cengage Learning
bartleby

Concept explainers

bartleby

Videos

Textbook Question
Book Icon
Chapter 10, Problem 21SP

CALCULATING THE WACC Here is the condensed 2019 balance sheet for Skye Computer Company (in thousands of dollars):

Chapter 10, Problem 21SP, CALCULATING THE WACC Here is the condensed 2019 balance sheet for Skye Computer Company (in

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 $30.00 per share. The firm’s before-lax cost of debt is 10%, and its marginal tax rate is 25%. 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. The firm’s total debt, which is the sum of the company’s short-term debt and long-term debt, equals $1.2 million.

  1. 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.
  2. b. Now calculate the cost of common equity from retained earnings, using the CAPM method.
  3. c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between r1 and rs as determined by the DCF method, and add that differential to the CAPM value for rs.)
  4. d. If Skye continues to use the same market-value capital structure, what is the firm’s WACC assuming that (1) it uses only retained earnings for equity and (2) if it expands so rapidly that it must issue new common stock?

a.

Expert Solution
Check Mark
Summary Introduction

To Determine: The after-tax cost of debt, cost of preferred stock, cost of common equity from retained earnings and cost of common equity from new common stock of Company SC.

Introduction: WACC is abbreviated as weighted average cost of capital, is a equation that computes the average rate of return that an organization requires to acquire to repay its security holders or investors. This computation is utilized to determine if a project is beneficial or in the event that it just repays the expense of subsidizing the project.

Answer to Problem 21SP

The after-tax cost of debt is 7.50%, cost of preferred stock is 11%, cost of common equity from retained earnings is 13.16% and cost of common equity from new common stock is 13.62%.

Explanation of Solution

Determine the after-tax cost of debt

AftertaxCostofDebt=[CostofDebt(rd)×(1TaxRate(T))]=[10%×(125%)]=[10%×75%]=7.50%

Therefore the after-tax cost of debt is 7.50%.

Determine the cost of preferred stock

CostofPreferredStock(rP)=[PreferredDividends(DP)CostofPreferredStock]=[$3.30$30]=11%

Therefore the cost of preferred stock is 11%.

Determine the cost of common equity from retained earnings

CostofRetainedEquity(rs)=[(D0(1+g)(P0))+g]=[($2.10×(1+9%)$55)+9%]=[0.04161+0.09]=0.13161or13.16%

Here,

D0 - Current dividend

g - Growth rate

P0 - Current price of bond

Therefore the cost of common equity from retained earnings is 13.16%.

Determine the cost of common equity from new common stock based on DCF

CostofCommonEquity(re)=[(D0×(1+g)P0×(1F))+g]=[($2.10×(1+9%)$55×(110%))+9%]=[($2.289$49.50)+9%]=[0.046242+0.09]=0.136242or13.62%

Here,

D0 - Current dividend

g - Growth rate

P0 - Current price of bond

F - Flotation cost

Therefore the cost of common equity from new common stock based on DCF is 13.62%.

b.

Expert Solution
Check Mark
Summary Introduction

To Determine: The cost of common equity from retained earnings of Company SC utilising CAPM method.

Answer to Problem 21SP

The cost of common equity from retained earnings of Company SC utilising CAPM method is 13.58%.

Explanation of Solution

Determine the cost of common equity from retained earnings using CAPM

CostofRetainedEquity(rs)=[rF+β×rM]=[6%+1.516×5%]=[0.06+0.0758]=0.1358or13.58%

Here,

rF - Risk free rate

rM - Market risk premium

B - Beta of stock

Therefore the cost of common equity from retained earnings using CAPM is 13.58%.

c.

Expert Solution
Check Mark
Summary Introduction

To Determine: The cost of new common equity based on CAPM.

Answer to Problem 21SP

The cost of new common equity based on CAPM is 14.04%.

Explanation of Solution

Determine the difference between the cost of common equity from retained earnings and cost of common equity from new common stock

Difference=[CostofCommonEquity(re)CostofRetainedEquity(rs)]=[13.62%13.16%]=0.46%

Therefore the difference between the cost of common equity from retained earnings and cost of common equity from new common stock is 0.46%

Determine the cost of new common equity based on CAPM

CostofNewCommonEquity(re)=[CostofRetainedEquity(rs)+Difference]=[13.58%+0.46%]=14.04%

Therefore the cost of new common equity based on CAPM is 14.04%.

d.

Expert Solution
Check Mark
Summary Introduction

To Determine: The WACC if the firm utilises only retained earnings for equity and if the firm expands rapidly in order to issue new common stock.

Answer to Problem 21SP

The WACC if the firm uses only retained earnings for equity and if the firm expands rapidly in order to issue new common stock

Explanation of Solution

Determine the market value of preferred stock

 MarketValuePreferredStock=[PricePreferredStock×SharesOutstandingFaceValue]=[$30×10,000$1,000]=[$300,000$1,000]=$300

Therefore the market value of preferred stock is $300

Determine the market value of debt

 MarketValueDebt=[LongTermDebt+ShortTermDebt]=[$1,100+$100]=$1,200

Therefore the market value of debt is $1,200

Determine the market value of common stock

MarketValueCommonStock=[PriceCommonStock×SharesOutstandingFaceValue]=[$55×50,000$1,000]=[$2,750,000$1,000]=$2,750

Therefore the market value of common stock is $2,750

Determine the total market value

TotalMarketValue=[MarketValueCommonStock+MarketValueDebt+MarketValuePreferredStock]=[$2,750+$1,200+$300]=$4,250

Therefore the total market value is $4,250

Determine the weight of preferred stock

 WeightPreferredStock=[MarketValuePreferredStockTotalMarketValue]=[$300$4,250]=0.07058or7.06%

Therefore the weight of preferred stock is 7.06%

Determine the weight of debt

 WeightDebt=[MarketValueDebtTotalMarketValue]=[$1,200$4,250]=0.28235or28.24%

Therefore the weight of debt is 28.24%

Determine the weight of common stock

 WeightCommonStock=[MarketValueCommonStockTotalMarketValue]=[$2,750$4,250]=0.64705or64.71%

Therefore the weight of common stock is 64.71%

Determine the WACC if the firm uses only retained earnings for equity

For the rate of common stock, the average of old and new common stock values are considered.

WACC=[(wd×rd×(1T))+(wp×rp×)+(we×re)]=[(28.24%×10%×(125%))+(7.06%×11%)+(64.71%×(13.16%+13.58%2))]=[(28.24%×7.50%)+(7.06%×11%)+(64.71%×13.37%)]=[0.02118+0.007766+0.086517]

            =0.115463or11.55%

Here,

wd - Weight of debt

rd - Rate of debt

T - Tax rate

wp - Weight of preferred stock

rp - Rate of preferred stock

we - Weight of common stock

re - Rate of common stock

Therefore the WACC if the firm uses only retained earnings for equity is 11.55%.

Determine the WACC if the firm expands rapidly in order to issue new common stock.

For the rate of common stock, the average of cost of new common equity based on CAPM and the cost of new common equity based on DCF values are considered.

WACC=[(wd×rd×(1T))+(wp×rp)+(we×re)]=[(28.24%×10%×(125%))+(7.06%×11%)+(64.71%×(14.04%+13.62%2))]=[(28.24%×7.50%)+(7.06%×11%)+(64.71%×13.83%)]=[0.02118+0.007766+0.089494]=0.11844 or11.84%

Therefore the WACC if the firm expands rapidly in order to issue new common stock is 11.84%.

Want to see more full solutions like this?

Subscribe now to access step-by-step solutions to millions of textbook problems written by subject matter experts!
Students have asked these similar questions
Here is the condensed 2019 balance sheet for Skye Computer Company (in thousands of dollars): Skye's earnings per share last year were $3.20. The common stock sells for $55.00, last year's dividend (Do) 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 $30.00 per share. The firm's before-tax cost of debt is 10%, and its marginal tax rate is 25%. 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. The firm's total debt, which is the sum of the company's short-term debt and long-term debt, equals $1.2 million.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…
The following are earnings and dividend forecasts made at the end of 2020 for the IBM Corporation with a $40 BV per common share at that time. In 2021, EPS will be $7 and DPS $1. In 2022, EPS will be $8 and DPS $1.50. In 2023, EPS will be $9 and DPS $2. The firm has a required equity return of 15% per year. Calculate the book value per share for the company for each year from 2021 to 2023, accordingly.
An investor estimates that next year’s sales for Dursley’s Hotels, Inc. should amount to about $100 million. The company has five million shares outstanding, generates a net profit margin of about 10%, and has a payout ratio of 50%. All figures are expected to hold for next year. Given this information, compute the following. .Estimated net earnings for next year Next year’s dividends per share The expected price of the stock (assuming the P/E ratio is 24.5 times earnings)

Chapter 10 Solutions

Fundamentals Of Financial Management, Concise Edition (mindtap Course List)

Knowledge Booster
Background pattern image
Finance
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.
Similar questions
SEE MORE QUESTIONS
Recommended textbooks for you
Text book image
Fundamentals Of Financial Management, Concise Edi...
Finance
ISBN:9781337902571
Author:Eugene F. Brigham, Joel F. Houston
Publisher:Cengage Learning
What is WACC-Weighted average cost of capital; Author: Learn to invest;https://www.youtube.com/watch?v=0inqw9cCJnM;License: Standard YouTube License, CC-BY