You develop the following information. Your firm has a target capital structure

Question

You develop the following information. Your firm has a target capital structure of 80% common equity, 5% preferred stock and 15% debt. The firm’s tax rate is 25%.

The firm can issue up to $225,000 worth of debt at a before-tax cost of 10%. Then it will cost the firm 11.5% before-tax on debt up to $300,000. After that point, the after-tax cost of debt will be 9.75%.

The firm’s preferred stock carries an annual dividend of $1.75 per share. The issue price of the preferred would be $20 with 2% of the issue price charged as flotation costs. The firm can use up to $125,000 of this preferred stock before the cost will increase to 10%.

The firm expects to have $1,500,000 in earnings and have a dividend payout ratio of 30%. The firm bases its cost of retained earnings on the CAPM approach. For this purpose, you determine the growth rate of the market will be 6% and the market dividend yield is 8%. The risk-free rate is 2.50%. The firm’s beta is 0.80.

The firm can issue new common stock with a $1.00 dividend, price of $25 per share, flotation costs of 4% of issue price and growth rate expected of 8%. This holds for up to $1,400,000 in equity after which it will cost 13% for new common stock.

Determine the marginal cost of capital schedule.

Explanation / Answer

We have to calculate the cost of debt and break points for each type of capital

First we calculat the cost of capital for debt and break even point

Break evn pint is given in the first case by = 225000/.15=1500000

Cost of Prefernce shares

= Dividend/Stock price

In stock price we should consider the floation cost also hence stock price should be = 20*1.02

Cost of prefernce shares = 1.75/(20*1.02)

=8.57%

Now let us calculate for equity

First what would be retained earnings would be = 150,000*(1-.3)=105,000

Cost of retained Earnings = Risk free rate + B((Rm _rf)

= 2.5% +.8*(6% -2.5%)

=5.3%

After this the cost of equity for issuing new common stock would be as follows :-

= D1/P +g

= 1/26 +8%

=11.84%

Debt raised BreaK point Pre tax cost of debt Post tax cost of debt 225000 1500000 10% 7.50% 300000 2000000 11.50% 8.63% > 300000 9.75%

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