Question

Marginal Incorporated (MI) has determined that the before cost of debt is 6% for the first $100 million in bonds it issues, and 8% for any bonds issued above $100 million. Its cost of preferred stock is 9%. The cost of internal equity is 12% and its cost of external equity is 14%. Currently, the firm’s capital structure has $600 million of debt, $100 million of preferred stock, and $300 million of common equity. The firm’s marginal tax rate is 30%. The firm is currently making projections for next period. Its managers have determined that the firm should have $75 million available from retained earnings for investment purposes next period.

What is the firm’s marginal cost of capital at each of the following total investment levels?        

1. Total investment level of $280 million?
2. II. Total investment level of $200 million?

III. Total investment level of $77 million?                                                                                                           

Answer 1

Cost of capital in order
After-tax cost of 1st $ 00 mln. Bond(6%*(1-30%))	4.2%
After-tax cost of next $ 100 mln. Bond(8%*(1-30%))	5.6%
Cost of Preferred stock	9%
Cost of Internal equity	12%
Cost of external equity	14%

Firm’s marginal cost of capital at
I. Total investment level of $280 million
		Amt.in mlns.	Wt. to total	Cost	Wt.*Cost
Retained earnings(Internal equity)		75	26.79%	12%	3.214%
Balance (280-75)=205 mlns.
Out of which(least to high cost of financing)
First $ 100 mln	Bonds	100	35.71%	4.20%	1.500%
Next $ 100 mln.	Bonds	100	35.71%	5.60%	2.000%
Balance (205-100-100)=5 mln.	Preferred stock	5	1.79%	9%	0.161%
		280	1		6.875%
Marginal cost of capital= 6.875%

II. Total investment level of $200 million
		Amt.in mlns.	Wt. to total	Cost	Wt.*Cost
Retained earnings(Internal equity)		75	37.50%	12%	4.500%
Balance (200-75)=125 mlns.
Out of which(least to high cost of financing)
First $ 100 mln	Bonds	100	50.00%	4.20%	2.100%
Balance $ 25 mln.	Bonds	25	12.50%	5.60%	0.700%
		200	1		7.300%
Marginal cost of capital= 7.3%

III. Total investment level of $77 million
		Amt.in mlns.	Wt. to total	Cost	Wt.*Cost
Retained earnings(Internal equity)	75	75	97.40%	12%	11.688%
Balance (77-75)	2	2	2.60%	4.20%	0.109%
		77			11.80%
Marginal cost of capital= 11.80%