Question

The Evans Corporation finds that it is necessary to determine its marginal cost of capital. Evans' current capital structure calls for 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Initially, common equity will be in the form of retained earnings (Ke) and then new common stock (Kn). The costs of the various sources of financing are as follows: debt, 6.2 percent; preferred stock, 9.4 percent; retained earnings, 12 percent; and new common stock, 13.4 percent.

1. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, K_e.)

2. If the firm has $20 million in retained earnings, at what size of investment will the firm run out of retained earnings?

3. What will the marginal cost of capital be immediately after that point? (Equity will remain at 60 percent of the capital structure, but it will all be in the form of new common stock, K_n.)

4. The 6.2 percent cost of debt referred to above applies only to the first $36 million of debt. After that, the cost of debt will be 7.8 percent. At what size of investment will there be a change in the cost of debt?

5. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.)

5. Thats all

Answer 1

PART a

Computation of weighted average cost of capital (WACC)

Particulars	Weights	Cost	Weighted cost
Debt	0.30	0.062	0.0186
Preferred stock	0.10	0.094	0.0094
Common equity	0.60	0.12	0.0720
			0.1000

WACC = 10%

PART b

Capital Structure Size = Retained Earnings / % of Retained earnings in Capital structure
Capital Structure Size = 20,000,000 / 0.60
Capital Structure Size = $33,333,333

PART c

Computation of marginal cost of capital

Particulars	Weights	Cost	Weighted cost
Debt	0.30	0.062	0.0186
Preferred stock	0.10	0.094	0.0094
New common stock	0.60	0.134	0.0804
			0.1084

Marginal cost of capital = 10.84%

PART d

Capital Structure Size = Amount of Lower Cost Debt / % of Debt within Capital Structure
Capital Structure Size = 36,000,000 / 0.30
Capital Structure Size = $120,000,000

(Only 4 sub-parts are allowed to be answered.)