Question

The chief financial officer of Portland Oil has given you the assignment of determining the firm's marginal cost of capital. The present capital structure which is considered optimal, is:

                                                 Book Value        Market Value  

     Debt                           $ 80 million          $ 60 million  

     Preferred Stock                     30 million              30 million  

     Common Equity                   100 million           210 million  

                 Total                                $210 million         $300 million  

  The anticipated financing opportunities are these: Debt can be issued with a 12 percent before-tax cost. Preferred stock will be $100 par, carry a dividend of 15 percent, and can be sold to net the firm $85 per share. Common equity has a beta of 1.20, the return on the market is 8 percent, and the risk-free rate is 2 percent. The firm's tax rate is 40 percent.  

     The company’s marginal cost of capital (MCC) is:

		11.47 percent
		10.60 percent
		9.38 percent
		8.34 percent
		9.64 percent

Answer 1

Given about Portland oil,

Market value of Debt = $60 million

Market value of preferred stock = $30 million

Market value of common stock = $210 million

So, Weight of debt Wd = MV of debt/Total merket value = 60/300 = 20%

Weight of preferred stock Wp = MV of preferred stock/total market value = 30/300 = 10%

Weight of common stock We = MV of common equity/total market value = 210/300 = 70%

befor tax cost of debt Kd = 12%

Preferred stock with par value of 100 and 15% dividend rate at valued at $85

So, cost of preferred stock Kp using prepetuity model is

Kp = Dividend/Price = 15/85 = 17.65%

beta of common equity = 1.2

risk free rate Rf = 2%

Expected return on market Rm = 8%

So, cost of equity Ke using CAPM is

Ke = Rf + beta*(Rm - Rf) = 2 + 1.2*(8 - 2) = 9.20%

Tax rate T = 40%

So, Marginal cost of capital = Wd*Kd*(1-T) + Wp*Kp + We*Ke = 0.2*12*(1-0.4) + 0.1*17.65 + 0.7*9.2 = 9.64%

So option E is correct.