Question

It is your job to determine your company’s marginal cost of capital schedule. The firm’s current capital structure, which it considers optimal, consists of 30% debt, 20% preferred stock, and 50% common equity. The firm has determined that it can borrow up to $15 million in debt at a pre-tax cost of 7%, an additional $9 million at a pre-tax cost of 9%, and any additional debt funds at 11%. The firm expects to retain $25 million of its earnings; any additional income can be raised by issuing new common stock. The firm’s common stock currently trades at $30 per share, and it pays a $3.00 per share dividend. Dividends are expected to grow at a 5% annual rate over time. If the firm issues new common stock it will be sold to the public at a 10% discount. There will also be a $2.00 per share flotation cost. Preferred stock can be issued in unlimited quantities at a pre-tax cost of 12%. If the firm decides to raise more than $80m in capital, what is the cost of that capital? Assume a tax rate of 40%.

Question 12 options:

	11.63%
	12.38%
	13.18%
	14.01%

Answer 1

Based on the input provided,

a) Cost of Retained Earning = (Dividend/ Current Market Price) + Dividend growth rate

b) Cost of new equity = (Dividend / (Discounted market price - Flotation Cost)) + Dividend growth rate

c) Cost of debt = Pre-tax cost * (1 - tax rate)

The WACC at the optimal capital structure Equity = 50%, Preferred Stock = 20% and Debt = 30% for $80 Million is shown below.

Fund Required	80.00	Cost	Weight	Cost x Weight
Retained Earnings	25.00	15.0%	31%	4.69%
New Equity issue	15.00	17.0%	19%	3.19%
Preferred Stock @ 12%	16.00	12.0%	20%	2.40%
Debt @ 7%	15.00	4.2%	19%	0.79%
Debt @ 9%	9.00	5.4%	11%	0.61%
Debt @ 11%	-	6.6%	0%	0.00%
WACC				11.67%

For funds above $80 Million, the WACC will increase above 11.67%.