Question

Delta Corporation has the following capital structure:

  

	Cost (aftertax)			Weights			Weighted Cost
Debt (Kd)		6.2	%		25	%		1.55	%
Preferred stock (Kp)		5.5			25			1.38
Common equity (Ke) (retained earnings)		15.5			50			7.75
Weighted average cost of capital (Ka)								10.68	%

a. If the firm has $22 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)
  

b. The 6.2 percent cost of debt referred to earlier applies only to the first $16 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)
  

Answer 1

A) Retained Earnings of the firm is standing at $22million, Weight of the retained earnings of the firm is pegged at 50%, so the optimal structure at which the firm will run out of retained earnings will be;

Retained earnings / Weight of common equity

Or, $22 million/ 0.5 = $44million.

So at $44million the firm will run out of retained earnings.

b) 6.2% is the cost of debt and the value of debt is $16million

So the optimal capital structure at which there will be a change in the cost of debt

Value of Debt/ Weight of Debt

Or, $16million/ 0.25= $64million.

So at $64million a change in the cost of debt will be found.