Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 5.0% for the first $58 million in bonds it issues, and 8.0% for any bonds issued above $58 million. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $530 million of debt, $150 million of preferred stock, and $320 million of common equity. The firm's marginal tax rate is 25%. The firm's managers have determined that the firm should have $58 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 $145 million?

12.15%

10.87%

9.68%

10.96%

13.21%

11.93%

Answer 1

Marginal cost of capital is the cost of capital for one additional dollar raised

Capital Budget = $145 million

To be financed through Equity = 145 million*320/1000 = 46.4 million

Available from retained earnings = $58 million

Hence, external equity will not be required

To be financed through debt = 145*530/1000 = 76.85 million

Hence, subsequent issue would be required

WACC = After tax Cost of debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

= 8%*(1-25%)*530/1000 + 15%*150/1000 + 17%*320/1000

=10.87%

i.e. 10.87%