Calculating the WACC

Calculating the WACC

The Weighted Average Cost of Capital (WACC) is a crucial financial metric that is used to determine the cost of financing for a company. It takes into account the different sources of capital, such as debt and equity, and their respective costs. In this essay, we will calculate the WACC for Skye Computer Company based on the given information.

a. Calculating the cost of each capital component

After-tax cost of debt

The after-tax cost of debt represents the cost of borrowing for a company. It can be calculated by multiplying the before-tax cost of debt by (1 – tax rate). In this case, the before-tax cost of debt is 10% and the tax rate is 25%.

After-tax cost of debt = 10% * (1 – 25%) = 7.5%

Cost of preferred stock

The cost of preferred stock is the dividend yield on the preferred stock. In this case, the dividend on preferred stock is $2.70 and the current price of preferred stock is $30.00.

Cost of preferred stock = Dividend on preferred stock / Current price of preferred stock = $2.70 / $30.00 = 9.0%

Cost of retained earnings

The cost of retained earnings represents the opportunity cost of retaining earnings within the company instead of distributing them to shareholders. It can be calculated using the Dividend Discount Model (DDM) or the Capital Asset Pricing Model (CAPM). In this case, we will use the CAPM.

Cost of new common stock

The cost of new common stock refers to the cost of issuing new shares in the market. It takes into account the flotation cost, which is the cost associated with issuing new securities. In this case, the flotation cost for common stock is 11%.

To calculate the cost of new common stock, we need to adjust the cost of retained earnings for the flotation cost.

b. Calculating the cost of common equity from retained earnings, using the CAPM method

The CAPM method is widely used to calculate the cost of equity. It takes into account the risk-free rate, market risk premium, and beta of a company’s stock.

In this case, the risk-free rate is 6%, the market risk premium is 5%, and the beta is 1.384.

Using the CAPM formula:

Cost of retained earnings = Risk-free rate + Beta * Market risk premium = 6% + 1.384 * 5% = 12.92%

c. Calculating the cost of new common stock based on the CAPM

To calculate the cost of new common stock, we need to adjust the cost of retained earnings for the flotation cost.

Flotation cost adjustment = Cost of retained earnings * (1 – Flotation cost) = 12.92% * (1 – 11%) = 11.49%

d. Calculating the firm’s WACC

The WACC is calculated by taking a weighted average of the costs of each capital component based on their respective proportions in the company’s capital structure.

Assuming that Skye Computer Company uses only retained earnings for equity, the weight for equity is 100% and there is no weight for new common stock.

Assuming that Skye Computer Company expands rapidly and needs to issue new common stock, we will assume that it accounts for 20% of its total equity.

Using these assumptions, we can now calculate the firm’s WACC.

WACC (assuming only retained earnings) = (Weight of debt * After-tax cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of equity * Cost of retained earnings)

WACC (assuming only retained earnings) = (0% * 7.5%) + (0% * 9.0%) + (100% * 12.92%) = 12.92%

WACC (assuming new common stock) = (Weight of debt * After-tax cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of retained earnings * Cost of retained earnings) + (Weight of new common stock * Cost of new common stock)

WACC (assuming new common stock) = (0% * 7.5%) + (0% * 9.0%) + (80% * 12.92%) + (20% * 11.49%) = 12.58%

In conclusion, based on the given information and calculations, Skye Computer Company’s WACC is 12.92% assuming only retained earnings and 12.58% assuming new common stock issuance. The WACC represents the minimum return that Skye Computer Company needs to generate in order to satisfy its investors and finance its operations effectively.