Question

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 7.0%. Its cost of preferred stock is 11.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $250 million of debt, $55 million of preferred stock, and $195 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 $64 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 $130 million?

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 5.0% for the first $198 million in bonds it issues, and 8.0% for any bonds issued above $198 million. Its cost of preferred stock is 11.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 20.0%. Currently, the firm's capital structure has $310 million of debt, $30 million of preferred stock, and $160 million of common equity. The firm's marginal tax rate is 35%. The firm's managers have determined that the firm should have $73 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 $137 million?

Answer 1

WACC = sum of (cost of capital*weight of capital)

Weight calculation:

Total capital = debt value + preferred stock value + common equity value = 310 + 30 + 160 = 500

Debt weight = debt value/total capital = 310/500 = 0.62

Preferred stock weight = preferred stock value/total capital = 30/500 = 0.06

Common equity weight = common equity value/total capital = 160.500 = 0.32

For an investment of 137 million, the required amount for each capital is:

Debt amount = debt weight*investment amount = 0.62*137 = 84.94 million (This amount is less than 198 million, so existing cost of debt will be used)

Preferred stock amount = 0.06*137 = 8.22 million

Common equity amount = 0.32*137 = 43.84 million (This amount is less than the allocated retained earnings amount of 73 million, so cost of retained earnings will be used)

WACC = (0.62*5%) + (0.06*11%) + (0.32*16%) = 8.88% (Marginal cost of capital for $137 investment)