Question

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 35 percent debt, 10 percent preferred stock, and 55 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), 5.6 percent; preferred stock, 11 percent; retained earnings, 8 percent; and new common stock, 9.2 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 $11 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 55 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 5.6 percent cost of debt referred to earlier applies only to the first $14 million of debt. After that, the cost of debt will be 7.6 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

(a) Initial weighted average cost of capital is 7.46%.

Particulars	Cost of capital (A)	Weights (B)	Weighted cost (A)*(B)
Debt (Kd)	5.60%	0.35	1.96%
Preferred stock (Kp)	11%	0.10	1.10%
Retained earnings	8%	0.55	4.40%
Initial weighted average cost of capital	7.46%

(b) Let the size of capital structure at which the firm will run out of retained earnings be X

X = Retained earnings / % of retained earnings within capital structure

= $11 million / 0.55

= $ 20 millions

(c) Marginal cost of capital as computed is 8.12%

Particulars	Cost of capital (A)	Weights (B)	Weighted cost (A)*(B)
Debt (Kd)	5.6%	0.35	1.96%
Preferred stock (Kp)	11.0%	0.10	1.10%
New common stock (Kn)	9.2%	0.55	5.06%
Marginal cost of capital	8.12%

(d) Let the size of capital structure at which there will be a change in the cost of debt be Y

Y = Amount of lower cost debt / % of debt within capital structure

=  $14 million / 0.35

= $40 millions

(e) New marginal cost of capital as computed is 8.82%

Particulars	Cost of capital (A)	Weights (B)	Weighted cost (A)*(B)
Debt (Kd)	7.6%	0.35	2.66%
Preferred stock (Kp)	11.0%	0.10	1.10%
New common stock (Kn)	9.2%	0.55	5.06%
New marginal cost of capital	8.82%