tiger inc. needs to raise $85,000 to purchase a new machine. Tiger knows its com

Question

tiger inc. needs to raise $85,000 to purchase a new machine. Tiger knows its component costs of capital are debt 5%, preferred stock 7%, new equity 13%, and retained earnings 11%. Tiger maintains a capital structure that consists of 60 percent debt, 10 percent preferred stock, and 30 percent common equity. The firm's marginal tax rate is 30 percent. If Tiger expects to generate $26,000 in retained earnings this year, what marginal cost of capital will it incur to raise the needed funds if needed?

Explanation / Answer

Factoring the marginal tax rate the Tiger Inc's cost of debt = 0.05 x (1-0.3) = 0.035 = 3.5%

Further tiger inc has $26000 in retained earnings hence it needs to raise 85000-26000= $59000 from debt, preferred stocks and equity in the ratio of 60, 10 and 30. Hence the amount of these components in overall funds would be-

Debt = 59000 x 0.60 = $35400

Preferred Stock = 59000 x 0.1 = $5900

Equity = 59000*0.3 = $17700

Now the marginal cost of capital to raise fund ($85000) needed by the company can be calculated as below:

   

Marginal Cost of Capital $=

a x b

Hence the company would incur $6813 as maginal cost of capital for the funds it needs to raise.

Component of capital structure Cost %(a) Amount (b)

Marginal Cost of Capital $=

a x b

Debt 3.5% 35400 1239 Preferred Stock 7% 5900 413 Equity 13% 17700 2301 Retained Earning 11% 26000 2860 Total - 85000 6813

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