Question

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 30 percent debt, 30 percent preferred stock, and 40 percent common equity. Initially, common equity will be in the form of retained earnings (K_e) and then new common stock (K_n). The costs of the various sources of financing are as follows: debt (after-tax), 8.5 percent; preferred stock, 6 percent; retained earnings, 12 percent; and new common stock, 13.2 percent.
a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, K_e.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)

b. If the firm has $18 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 40 percent of the capital structure, but will all be in the form of new common stock, K_n.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

d. The 8.5 percent cost of debt referred to earlier applies only to the first $24 million of debt. After that, the cost of debt will be 10.5 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

Solution:

a)Calculation of weighted average cost of capital(WACC)

WACC=Cost of retained Earning*Weight of retained Earning+Cost of preferred stock*Weight of preferred stock+After tax cost of debt*Weight of debt

=12%*0.40+6%*0.30+8.50%*0.30

=4.8%+1.8%+2.55%=9.15%

b)Calculation of Capital structure

=Retained Earning/Weight of retained earning

=$18 million/0.40=$45million

Firm will run out of retained earning at $45 million

c)Calculation of marginal cost of capital

Marginal cost of capital is;

=Kn*Weight of common equity+Cost of preferred stock*Weight of preferred stock+After tax cost of debt*Weight of debt

=13.2%*0.40+6%*0.30+8.50%*0.30

=5.28%+1.8%+2.55%

=9.63%

d)Calculation of Capital structure where there is a change in the cost of debt

=Amount of lower cost of debt/Weight of debt

=$24 million/0.30

=$80 million

e)Calculation of Marginal cost of capital

Marginal cost of capital is;

=Kn*Weight of common equity+Cost of preferred stock*Weight of preferred stock+After tax cost of debt*Weight of debt

=13.2%*0.40+6%*0.30+10.50%*0.30

=5.28%+1.80%+3.15%

=10.23%