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

Solution Capital Structure Weights

Debt          600 / 1000 = 0.6

Pref           100 / 1000 = 0.1

Equity 300 / 1000 = 0.3

TOTAL    1000

Next, calculate the breakpoints. (There are two breakpoints in this problem since the cost of debt can be either 6% or 8% and the cost of equity can be 12% or 14%.)

Breakpoint(debt) = 100/0.6 = 167 million

Breakpoint(equity) = 75/0.3 = 250 million

Now calculate the WACC for each total investment level. You do not adjust the cost of debt for taxes since you are given the after-tax cost of debt.

A)

$280 million total investment level

The total investment level exceeds the breakpoint for debt (280 >167), so you use the higher cost of debt.

The total investment level exceeds the breakpoint for equity (280 > 250), so you use the higher cost of equity.

WACC = (0.6)(8%) + (0.1)(9%) + (0.3)(14%) = 9.90%

B)

$200 million total investment level

The total investment level exceeds the breakpoint for debt (200 > 167), so you use the higher cost of debt.

The total investment level is less than the breakpoint for equity (200 < 250),so you use the lower cost of equity.

WACC = (0.6)(8%) + (0.1)(9%) + (0.3)(12%) = 9.30%

C)

$77 million total investment level

The total investment level is less than the break point for debt (77 < 167),so you use the lower cost of debt.

The total investment level is less than the break point for equity (77 < 250),so you use the lower cost of equity.

WACC = (0.6)(6%) + (0.1)(9%) + (0.3)(12%) = 8.10%