Question

Delta Corporation has the following capital structure:

  

	Cost (aftertax)			Weights			Weighted Cost
Debt (Kd)		9.5	%		30	%		2.85	%
Preferred stock (Kp)		9.2			15			1.38
Common equity (Ke) (retained earnings)		16.2			55			8.91
Weighted average cost of capital (Ka)								13.14	%

a. If the firm has $22 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").)
  

b. The 9.5 percent cost of debt referred to earlier applies only to the first $36 million of debt. After that the cost of debt will go up. 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").)

Answer 1

Solution:
a.	Capital structure size     $	40	million
Working Notes:
	Capital structure size =Retained earnings /weight of Common equity
		=$22 million /55%
		=$40 million
	Size of capital structure at which firm run out of retained earnings means the retained earnings will be 100% invested, and for 55% common equity of $22 million retained earnings should be 55% of total capital , so the total capital structure = Retained earnings /weight of Common equity
b.	Capital structure size         $	120	million
Working Notes:
	Capital structure size =Amount of lower cost debt / Weight of debt
		=$36 million / 30%
		=$120 million
	Since, at 9.5 percent cost of debt referred to earlier applies only to the first $36 million of debt. After that the cost of debt will go up , hence the capital structure above =amount of debt/weight of debt means above the current capital structure in which $36 million is debt and above that cost of debt will go up.
Please feel free to ask if anything about above solution in comment section of the question.