The Sarco Company has a target capital structure of 30% debt, 10% preferred stoc

Question

The Sarco Company has a target capital structure of 30% debt, 10% preferred stock and 60% common equity from retained earnings. Sarco finished its most recent fiscal with $57 million in retained earnings and would like to raise capital to expand its operations.

Given the information provided above, What is Sarco’s retained earnings breakpoint?

A. 92,000,000

B. 93,000,000

C. 94,000,000

D. 95,000,000

Given the information provided above, how much new debt can Sarco raise and still maintain its current capital structure?

Given the information provided above, how much new preferred stock can Sarco raise and still maintain its current capital structure?

Explanation / Answer

Total Capital Structure is broken down into 3 portions

30% Debt

10% Preferred stock

60% equity but from retained earnings

In current fiscal year the company had $57 million of retained earnings

So Sarco’s retained earnings breakpoint would be = Current Fiscal retained Earnings/ % of equity from retained earnings

Or, Sarco’s retained earnings breakpoint = $57/ 0.6 = $95million or $95,000,000

Hence option (D) is correct.

Again $95 million is the 60% of the total capital structure of the company, hence full value of Sarco would be;

$95/0.6= $158.33 million

Now Debt has 30% stake in the capital structure therefore new debt that Sarco can raise to maintain its capital structure would be $158.33*0.3 = $47.5 million

Again Preferred stock has 10% weight in the capital structure therefore new preferred stock that Sarco can raise to maintain its capital structure would be $158.33*0.10 = $15.833 million

Thus without affecting the previous capital structure new values of debt, preferred and common equity would be;

Debt capital (30%) = $47.50 million

Preferred stock (10%) = $15.8333 million

Equity capital (60%) = $95million

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