The McGee Corporation finds it is necessary to determine its marginal cost of ca

Question

The McGee Corporation finds it is necessary to determine its marginal cost of capital. McGee’s current capital structure calls for 50 percent debt, 20 percent preferred stock, and 30 percent common equity. Initially, common equity will be in the form of retained earnings (Ke) and then new common stock (Kn). The costs of the various sources of financing are as follows: debt, 5.2 percent; preferred stock, 7.0 percent; retained earnings, 10.0 percent; and new common stock, 11.2 percent.

a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, Ke.) (Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.) Weighted Cost Debt (Kd) % Preferred stock (Kp) Common equity (Ke) Weighted average cost of capital (Ka) %

b. If the firm has $22.5 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").) Capital structure size (X) $ million

c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 30 percent of the capital structure, but will all be in the form of new common stock, Kn.) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Marginal cost of capital %

d. The 5.2 percent cost of debt referred to above applies only to the first $42 million of debt. After that, the cost of debt will be 7.2 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").) Capital structure size (Z) $ million

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.) Marginal cost of capital %

Explanation / Answer

Part 1)

The weighted average cost of capital can be calculated with the use of following formula:

WACC = Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of Equity

_________

Using the values provided in the question, we get,

WACC (Ka) = 50%*5.2% + 20%*7% + 30%*10% = 7%

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Part 2)

The size of capital structure at which the firm will run out of retained earnings is calculated as follows:

Amount = Retained Earnings/Percentage of Retained Earnings in the Capital Structure = 22.5/30% = $75 million

__________

Part 3)

The marginal cost of capital is calculated as follows:

Marginal Cost of Capital = Weight of Debt*After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of New Common Stock

_________

Using the values provided in the question, we get,

MCC (Kn) = 50%*5.2% + 20%*7% + 30%*11.2% = 7.36%

__________

Part 4)

The size of capital structure at which there will be a change in debt is calculated as follows:

Amount = Value of Debt at Lower Cost/Percentage of Debt within the Capital Structure = 42/50% = $84 million

__________

Part 5)

The marginal cost of capital is calculated as follows:

Marginal Cost of Capital = Weight of Debt*Revised After-Tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Equity*Cost of New Common Stock

_________

Using the values provided in the question, we get,

MCC (Kn) = 50%*7.2% + 20%*7% + 30%*11.2% = 8.36%

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