Question

Marginal Incorporated (MI) has determined that its before-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

Answer 1

The marginal cost of capital is 10.18%( 10.2% when rounded to 1 decimal place)

Step-by-step explanation:

The requirement, in this case, is to ascertain the firm's cost of capital, its weighted average cost of capital, which is the sum of the after-tax cost of each component source of capital multiplied by their weight in the firm's capital structure, on the premise that the first $67 million would be from the internal equity, retained earnings

Balance of investment(after retained earnings)=$155-$67

Balance of investment(after retained earnings)=$88 million

Out of the $88 million,$74 million would be financed by debt which is a before-tax cost of 5.0% and the $14 million($88-$74) would be from additional debt which has a pretax cost of debt of 9.0% because raising additional debt is cheaper compared preferred equity and external equity whose costs are 15.0% and 22.0% respectively.

The after-tax costs of debt are computed thus:

after-tax cost for 5.0%=5.0%*(1-25%)

after-tax cost for 5.0%=3.75%

after-tax cost for 9.0%=9.0%*(1-25%)

after-tax cost for 9.0%=6.75%

WACC=(value of internal equity/total investment*cost of internal equity)+ (value of initial debt/total investment*after-tax cost of debt)+(value of additional debt/total investment*after-tax cost of debt)

WACC=(67/155*18.0%)+(74/155*3.75%)+(14/155*6.75%)

WACC=10.18%