Question

The McGee Corporation finds it is necessary to determine its marginal cost of capital. McGee’s current capital structure calls for 35 percent debt, 25 percent preferred stock, and 40 percent common equity. Initially, common equity will be in the form of retained earnings (K_e) and then new common stock (K_n). The costs of the various sources of financing are as follows: debt (after-tax), 5.4 percent; preferred stock, 9.0 percent; retained earnings, 10.0 percent; and new common stock, 11.2 percent.

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


b. If the firm has $36.0 million in retained earnings, at what size capital structure will the firm run out of retained earnings?


c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 40 percent of the capital structure, but will all be in the form of new common stock, K_n.)



d. The 5.4 percent cost of debt referred to above applies only to the first $42 million of debt. After that, the cost of debt will be 7.4 percent. At what size capital structure will there be a change in the cost of debt?
  

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

Answer 1

Initial Weighted average cost of capital = Cost of debt*Weight of debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 5.4%*35% + 9%*25% + 10%*40%

= 8.14%

b.Capital Structure = Amount in retained earnings/Share of Equity

= 36 million/40%

= $90 million

c.Marginal cost of capital = 5.4%*35% + 9%*25% + 11.2%*40%

= 8.62%

d.Change in cost of debt = 42 million/35%

= $120 million

e. MCC = 7.4%*35% + 9%*25% + 11.2%*40%

= 9.32%