Question

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 40 percent debt, 10 percent preferred stock, and 50 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, 6.6 percent; preferred stock, 6 percent; retained earnings, 11 percent; and new common stock, 12.2 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.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)
  b. If the firm has $10 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)

c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 50 percent of the capital structure, but will all be in the form of new common stock, K_n.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  d. The 6.6 percent cost of debt referred to earlier applies only to the first $20 million of debt. After that, the cost of debt will be 8.2 percent. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions of dollars (e.g., $10 million should be entered as "10").)

e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Answer 1

a. Weight of debt = 40%, Weight of preferred stock = 10%, Weight of common equity in form of retained earnings = 50%

Cost of debt = 6.6%, Cost of preferred stock = 6% and cost of retained earnings = 11%

Initial Weighted average cost of capital = Weight of debt x Cost of debt + Weight of preferred stock x Cost of preferred stock + Weight of common equity in form of retained earnings x cost of retained earnings = 40% x 6.6% + 10% x 6% + 50% x 11% = 2.64% + 0.60% + 5.50% = 8.74%

Hence Initial weighted average cost of capital = 8.74%

b. Amount of retained earnings = $10 million

Weight of common equity in form of retained earnings = 50%

Breakeven point of retained earnings = Amount of retained earnings / Weight of common equity in form of retained earnings = 10 million / 50% = 20 million

Breakeven point of retained earnings represents the size of capital structure at which firm will run out of its retained earnings and after that point there will change in cost of common equity

The firm will run out of its retained earnings at capital structure = 20 million

c. Once the firm runs out of its retained earnings, equity will be in form of new common stock

Weight of debt = 40%, Weight of preferred stock = 10%, Weight of common equity in form of new common stock = 50%

Cost of debt = 6.6%, Cost of preferred stock = 6% and cost of new common stock = 12.2%

Marginal Weighted average cost of capital = Weight of debt x Cost of debt + Weight of preferred stock x Cost of preferred stock + Weight of common equity in form of new common stock x cost of new common stock = 40% x 6.6% + 10% x 6% + 50% x 12.2% = 2.64% + 0.60% + 6.10% = 9.34%

Hence, Marginal weighted average cost immediately after firm runs out of its retained earnings = 9.34%

d.Amount of Debt after which cost of debt changes = $20 million

Weight of debt = 40%

Breakeven point of debt = Amount of Debt after which cost of debt changes / Weight of Debt = 20 million / 40% = 50 million

Breakeven point of debt represents the size of capital structure at which there will change in cost of debt.

Hence there will be change in cost of debt at capital structure = 50 million

e. Immediately after capital structure of 50 million, we will have new cost of debt and equity will also be in form of new common stock

Weight of debt = 40%, Weight of preferred stock = 10%, Weight of common equity in form of new common stock = 50%

Cost of debt = 8.2%, Cost of preferred stock = 6% and cost of new common stock = 12.2%

Marginal Weighted average cost of capital = Weight of debt x Cost of debt + Weight of preferred stock x Cost of preferred stock + Weight of common equity in form of new common stock x cost of new common stock = 40% x 8.2% + 10% x 6% + 50% x 12.2% = 3.28% + 0.60% + 6.10% = 9.98%

Marginal cost of capital immediately after change in cost of debt = 9.98%