Here is the condensed 2005 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, last year’s dividend was $2.10, and a flotation cost of 10 percent would be required to sell new common stock. Security analysts are projecting that the common dividend will grow at a rate of 9 percent per year. Skye’s preferred stock pays a dividend of $3.30 per share, and new preferred could be sold at a price to net the company $30 per share. The firm can issue long-term debt at an interest rate (or before-tax cost) of 10 percent, and its marginaltax rate is 35 percent. The market risk premium is 5 percent, the risk-free rate is 6 percent, 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. 

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. 

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?  

d. If Skye 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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Current assets Net fixed assets Total assets Current liabilities Long-term debt Preferred stock Common stock Retained earnings Total common equity Total liabilities and equity 2005 $2,000 3,000 $5,000 $ 900 1,200 250 1,300 1,350 $2,650 $5,000