Question

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 10.0%. Its cost of preferred stock is 14.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $372 million of debt, $30 million of preferred stock, and $198 million of common equity. The firm's marginal tax rate is 25%. The firm is currently making projections for the next period. Its managers have determined that the firm should have $70 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 $255 million?

Answer 1

Current Capital Structure: $ 372 million Debt, $ 30 million Preferred Stock, $ 198 million Common Stock, Total Capital = 372 + 30 + 198 = $ 600 million

Debt Proportion = (372/600) = 0.62. Preferred Stock = 30/360 = 0.05 and Common Stock = 198 / 600 = 0.33

Retained Earnings Available = $ 70 million

Now whenever the firm raises fresh capital it is assumed that the firm raises it in a ratio matching its existing capital structure.

Therefore, if target capital value is $ 255 million, 0.62 of it will be debt, 0.33 will be common stock and 0.05 will be preferred stock.

Equity Raised = 0.33 x 255 = $ 84.15 million, of which $ 70 million is retained earnings (internal equity) and the remaining is external equity.

Proportion of Internal Equity = (70/255) = 0.2745 and Proportion of External Equity = (14.15/255) = 0.0555

Cost of Debt = 10%, Cost of Preferred Stock = 14%, Cost of internal Equity = 16% and Cost of External Equity = 21%

Tax Rate = 25 %

Therefore, Marginal Cost of Capital = 0.62 x 10 + 0.05 x 14 + 0.2745 x 16 + 0.0555 x 21 = 12.4575 % ~ 12.46 %