332 Part 4 Investing in Long-Term Assets: Capital Budgeting
The current interest rate on new debt is 9%; Foust’s marginal tax rate is 40%; and its capi-
tal structure, considered to be optimal, is as follows:Debt $104,000,000
Common equity 156,000,000
Total liabilities and equity $260,000,000a. Calculate Foust’s after-tax cost of debt and common equity. Calculate the cost of
equity as rs! D 1 /P 0 # g.
b. Find Foust’s WACC.CALCULATING THE WACC Here is the condensed 2008 balance sheet for Skye Computer
Company (in thousands of dollars):2008
Current assets $2,000
Net fixed assets 3,000
Total assets $5,000Current 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 $5,000Skye’s earnings per share last year were $3.20, the common stock sells for $55.00, last
year’s dividend was $2.10, and a flotation cost of 10% would be required to sell new com-
mon stock. Security analysts are projecting that the common dividend will grow at a rate
of 9% per year. Skye’s preferred stock pays a dividend of $3.30 per share, and new pre-
ferred could be sold at a price to net the company $30.00 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
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 dis-
regards 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 is-
sued common stock. Use the DCF method to find the cost of common equity.
b. Now calculate the cost of common equity from retained earnings using the CAPM
method.
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.)
d. If Skye continues to use the same capital structure, what is the firm’s WACC assum-
ing that (1) it uses only retained earnings for equity? (2) If it expands so rapidly that it
must issue new common stock?