Question

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 5.0% for the first $74 million in bonds it issues, and 9.0% for any bonds issued above $74 million. Its cost of preferred stock is 15.0%. Its cost of internal equity is 18.0%, and its cost of external equity is 22.0%. Currently, the firm's capital structure has $400 million of debt, $60 million of preferred stock, and $540 million of common equity. The firm's marginal tax rate is 25%. The firm's managers have determined that the firm should have $67 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 $155 million?

15.48%

16.38%

12.62%

14.22%

14.78%

14.28%

12.12%

13.32%

Answer 1

Market Value of Debt = $400million

Market Value of Equity = $540million

Market Value of Preferred Stock = $60million

Market Value of Retained Earnings = $67million

Total Market Value of the firm = $(400million + 540million + 60million+ 67million) = $1067million

Cost of Debt (Post-tax) = 5% (<74million Debt)

Cost of Debt (post-tax) = 9% (>74million Debt)

Cost of Preferred Stock = 15%

Cost of External Equity = 22%

Cost of Internal Equity = 18%

WACC = $74*0.05/ 1067 + $326*0.09/1067 + $540* 0.22/ 1067 + $60* 0.15/1067 + $67* 0.18/ 1067 = 0.35% + 2.75% + 11.14% + 0.84% + 1.13% = 16.21% ~ 16.38%

So the correct option is option (b)