Question

10. The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 30 percent debt, 30 percent preferred stock, and 40 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, 8.5 percent; preferred stock, 6 percent; retained earnings, 12 percent; and new common stock, 13.2 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.)

	Weighted Cost Debt % Preferred stock Common equity Weighted average cost of capital 0.00 %

b. If the firm has $18 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 40 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 8.5 percent cost of debt referred to earlier applies only to the first $24 million of debt. After that, the cost of debt will be 10.5 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

Weighted average cost of capital
source	cost of the source	weights/proportions(%)	proportional cost(%)
DEBT	8.5	30%	2.55
PREFERENCE STOCK	6	30%	1.8
COMMON EQUITY	12	40%	4.8
WACC =			9.15
b)
Size of the capital structure at which reatained earnings will be zero
The proportion of retained earnings in the capital sturcture is 40%.
so 40% must be equal to total retained earnings = $18 million
Then 100% is total capital structure = (100/40 ) X $18million
= $45 million
Formula = Amount of funds avilable from that source / Capital structure weight
c)
Marginal cost of capital (As cost of new equity is considered)
source	cost of the source	weights/proportions(%)	proportional cost(%)
DEBT	8.5	30%	2.55
PREFERENCE STOCK	6	30%	1.8
COMMON EQUITY	13.2	40%	5.28
WACC =			9.63
d)
Size of the capital structure at which there will be a change in cost of debt
The proportion of bebt in the capital sturcture is 30%.
so 30% must be equal to total debt @ 8.5% cost = $24 million
Then 100% is total capital structure = (100/30 ) X $24million
= $80million
e)
Marginal cost of capital (As cost of new equity and debt is considered)
source	cost of the source	weights/proportions(%)	proportional cost(%)
DEBT	10.5	30%	3.15
PREFERENCE STOCK	6	30%	1.8
COMMON EQUITY	13.2	40%	5.28
WACC =			10.23