Question

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 5.0% for the first $58 million in bonds it issues, and 8.0% for any bonds issued above $58 million. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $530 million of debt, $150 million of preferred stock, and $320 million of common equity. The firm's marginal tax rate is 25%. The firm's managers have determined that the firm should have $58 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 $272 million?

Answer 1

Firm's Current capital structure
				Weights
Debt		530		0.53
Preferred stock		150		0.15
Common equity		320		0.32
		1000		1
Total Capital budget is $272 million. Out of which $58 million is available from retained earnings.
Balance $214 million shall be obtained as Per current weight
Bond issued = 214 * 0.53 =				113.42
Preferred stock issued = 214*0.15 =				32.10
Equity issued= 214 * 0.32 =				68.48
Calculation of Marginal cost of capital
				Cost of capital	Weights	(weights * CoC)
Bonds ($58 million)				5%	58.00	2.9
Bonds (after $58 million)				8%	55.42	4.4336
Preferred stock				15%	32.10	4.815
Internal equity				17%	58.00	9.86
External equity				21%	68.48	14.3808
					272.00	36.3894
Marginal cost of capital = 36.3894/272 =				0.133784559
				or 13.38%
So, Marginal cost of capital is 13.38%