Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 13.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 22.0%. Currently, the firm's capital structure has $310 million of debt, $60 million of preferred stock, and $130 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for the next period. Its managers have determined that the firm should have $97 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $466 million?

9.05%

10.35%

9.70%

12.86%

11.56%

Answer 1

The correct answer is second option : 10.35%

All financials below are in $ mn.

First, let's examine the current capital structure. Please see the table below:

Component	Value	Proportion in total
Debt	310	310 / 500 = 62.00%
Preferred stock	60	60 / 500 = 12.00%
Common equity	130	130 / 500 = 26.00%
Total	500	100.00%

97 will be available from retained earnings for investment purposes next period

Hence, break even capital = Internal equity / proportion of common equity in existing capital structure = 97 / 26% = 373 < Planned investment next year = $ 466.

Hence, the marginal capital structure will comprise of external equity available at cost of 22%.

Hence, the firm's marginal cost of capital at a total investment level of $466 million = 62% x Kd x (1 - T) + 12% x Ks + 26% x Ke = 62% x 9% x (1 - 45%) + 12% x 13% + 26% x 22% = 0.10349 = 10.35%