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 (K_e) and then new common stock (K_n). The costs of the various sources of financing are as follows: debt, 9.2 percent; preferred stock, 8 percent; retained earnings, 9 percent; and new common stock, 10.2 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.)
  

b. If the firm has $31 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, K_n.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

d. The 9.2 percent cost of debt referred to earlier applies only to the first $9 million of debt. After that, the cost of debt will be 11.2 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.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

Answer 1

a)

after tax cost of debt = 9.2

weight of debt = 30%

weighted cost of debt = 9.2 * 0.3 = 2.76

Cost of preferred stock = 8%

Weight of preferred stock = 20%

weighted cost of preferred stock = 8 * 0.2 = 1.6%

Common equity (retained earnings) = 9%

weight of common equity = 50%

Weighted cost of common equity = 9 * 0.5 = 4.5%

Weighted average cost pf capital = 2.76 + 1.6 + 4.5 = 8.86%

b)

capital at which it run out earnings can be found by

C = Retained earnings / weight of retained earnings in the total capiatl structure

= 31 / 0.5

= 62 Million

c)

after tax cost of debt = 9.2

weight of debt = 30%

weighted cost of debt = 9.2 * 0.3 = 2.76

Cost of preferred stock = 8%

Weight of preferred stock = 20%

weighted cost of preferred stock = 8 * 0.2 = 1.6%

New common stock cost = 10.2 %

weight of common stock = 0.5

Weighted cost of new common stock = 10.2 * 0.5 = 5.1%

Marginal cost of capital = 2.76 + 1.6 + 5.1 = 9.46%

d)

capital structure at which the cost of debt changes;

C = Amount with lower cost of debt / weight of debt in the capital structure

= 9 / 0.3 = 30 million

e)

after tax cost of debt = 11.2

weight of debt = 30%

weighted cost of debt = 11.2 * 0.3 = 3.36

Cost of preferred stock = 8%

Weight of preferred stock = 20%

weighted cost of preferred stock = 8 * 0.2 = 1.6%

New common stock cost = 10.2 %

weight of common stock = 0.5

Weighted cost of new common stock = 10.2 * 0.5 = 5.1%

Weighted cost of capital = 3.36+ 1.6 + 5.1 = 10.06%