Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of...

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%

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%

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