Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 13.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 22.0%. Currently, the firm's capital structure has $310 million of debt, $60 million of preferred stock, and $130 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for the next period. Its managers have determined that the firm should have $97 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $269 million?

Answer 1

There are 3 steps to this question:

• Calculation of post tax cost of debt: The post tax cost of debt can be calculated as:

• Next step is to calculate the company's weighted average cost of capital (WACC) which is computed by taking the weighted average of cost of post tax debt, cost of preferred equity and cost of common stock (The cost of common stock is equivalent to the cost of external equity)
• Then we can calculate the marginal cost of raising 269 million. Out of this 269, 97 can be funded by retained earnings which carries a cost of 17% (cost of internal equity is the cost of using retained earnings to fund projects). The rest 172 has to be raised at the company's WACC. Taking the weighted averages of these two costs, one can compute the the company's marginal cost in this case.

The computations are as shown:

So, the answer is 12.75%