Question

The McGee Corporation finds it is necessary to determine its marginal cost of capital. McGee’s current capital structure calls for 50 percent debt, 20 percent preferred stock, and 30 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, 6.0 percent; preferred stock, 8.0 percent; retained earnings, 9.0 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, Ke.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) b. If the firm has $34.5 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 30 percent of the capital structure, but will all be in the form of new common stock, Kn.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) d. The 6.0 percent cost of debt referred to above applies only to the first $35 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

Answer:

The McGee Corporation

A)

	Cost (after tax)	Weights	Weighted Cost
Debt (Kd)	6.0	50%	3.0%
Preferred stock(Kp)	8.0	20%	1.60%
Common equity (Ke) (retained earnings)	9.0	30%	2.70%
Weighted average cost of capital(Ka)			7.30%

B) X = Retained earnings/% of retained earnings within the capital structure

         = 34.5 Million/0.30 = $115 Million

C)

	Cost (after tax)	Weights	Weighted Cost
Debt (Kd)	6.0%	50%	3.0%
Preferred stock (Kp)	8.0%	20%	1.60%
New common stock (Kn)	10.20%	30%	3.06%
Marginal cost of capital (Kmc)			7.66%

                          

D) Z=Amount of lower cost debt/% of debt within the capital structure

     = $35 Million/0.50 = $70 Million

E)

	Cost (after tax)	Weights	Weighted Cost
Debt (Kd)	11.20%	50%	5.60%
Preferred stock (Kp)	8.0%	20%	1.60%
New common stock (Kn)	10.20%	30%	3.06%
Marginal cost of capital (Kmc)			10.26%