Question

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 6.0% for the first $134 million in bonds it issues, and 10.0% for any bonds issued above $134 million. Its cost of preferred stock is 15.0%. Its cost of internal equity is 18.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $276 million of debt, $30 million of preferred stock, and $294 million of common equity. The firm's marginal tax rate is 35%. The firm's managers have determined that the firm should have $89 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 $109 million?

13.80%

14.03%

12.83%

12.56%

15.64%

11.36%

Answer 1

Existing weights	Capital	Weight	Explanation
Equity	$                   294	49.00%	= 294/600
Debt	$                   276	46.00%	= 276/600
Preferred	$                     30	5.00%	= 30/600
Total	$                   600	100.00%
New investment	$                   109
Finance from:	Amount	× cost	Expected return
Internal equity	$                53.41	18%	$           9.61
	[ 109 × 0.49 ]
Debt	$                50.14	6.50%	$           3.26
	[ 109 × 0.46 ]
Preferred	$                  5.45	15%	$           0.82
	[ 109 × 0.05 ]
	$             109.00		$         13.69
Marginal cost of capital	= 13.69/109=	12.56%

Answer is:

12.56%

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