Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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
$5,000
Current liabilities $ 900
Long-term debt 1,200
Common stock 1,300
Retained earnings
1,350
Total common equity
$2,650
Total liabilities and equity
$5,000
Skye’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 common
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 preferred
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 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
b. Now calculate the cost of common equity from retained earnings using the
c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference b betweenre 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 assuming t that(1) it uses only retained earnings for equity? (2) If it expands so rapidly that it must issue new common stock?
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