Question

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 30 percent debt, 20 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 (after-tax), 7.6 percent; preferred stock, 7 percent; retained earnings, 13 percent; and new common stock, 14.2 percent. a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, Ke.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) b. If the firm has $14 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, Kn.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) d. The 7.6 percent cost of debt referred to earlier applies only to the first $21 million of debt. After that, the cost of debt will be 9.2 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.)

Answer 1

WACC = sum of weighted costs of capital

a). Initial WACC = 10.18%

	Weight (w)	Cost ('c)	Initial WACC (w*c)
Debt (D)	30%	7.60%	2.28%
Preferred stock (P)	20%	7.00%	1.40%
Retained earnings (RE)	50%	13.00%	6.50%
New common stock (CS)		14.20%
		WACC	10.18%

b). The firm will run out of retained earnings when its capital structure reaches the point where 50% of the capital is 14 million (100% of retained earnings is utilized.) Total capital = 14/0.5 = 28 million.

c). Marginal cost of capital immediately after this point = 10.78%

	Weight (w)	Cost ('c)	WACC when RE runs out (w*c)
Debt (D)	30%	7.60%	2.28%
Preferred stock (P)	20%	7.00%	1.40%
Retained earnings (RE)		13.00%
New common stock (CS)	50%	14.20%	7.10%
		WACC	10.78%

d). Cost of debt will be 9.2% when capital is 21/30% = 70 million (all debt of 21 million available at 7.6% cost is utilized.)

e). Marginal cost of capital immediately after this point = 11.26%

	Weight (w)	Cost ('c)	WACC when debt amount changes (w*c)
Debt (D)	30%	9.20%	2.76%
Preferred stock (P)	20%	7.00%	1.40%
Retained earnings (RE)
New common stock (CS)	50%	14.20%	7.10%
			11.26%