Jones Industries has a current capital structure of 50% debt, 30% preferred stoc

Question

Jones Industries has a current capital structure of 50% debt, 30% preferred stock, and 20% common equity. The company is trying to determine its marginal cost of capital. Assume that initially, common equity will be in the form of retained earnings and then new common stock. Assume the following as costs of the various sources of financing:

Debt = 9.6%, Preferred stock = 9%, Retained Earnings = 10%, New common stock = 11.2%

Part 2: If the firm has $18 million in retained earnings, at what size capital structure will the firm run out of retained earnings? What will the marginal cost of capital be immediately after that point? Assume that equity will remain in the capital structure at 20%, but will all be in the form of new common stock.

Select one:

a. $90 million, 9.74%

b. $90 million, 10.69%

c. $87 million, 10.62%

d. $96 million, 7.98%

e. $93 million, 9.74%

f. $87 million, 8.79%

Explanation / Answer

Answer a.

Retained Earnings = $18 million
Weight of Common Equity = 20%

Size of Capital Structure = Retained Earnings / Weight of Common Equity
Size of Capital Structure = $18 million / 0.20
Size of Capital Structure = $90 million

Answer b.

Weight of Debt = 50%
Weight of Preferred Stock = 30%
Weight of Common Equity = 20%
Cost of Debt = 9.6%
Cost of Preferred Stock = 9%
Cost of New Common Equity = 11.2%

Cost of Capital = Weight of Debt*Cost of Debt + Weigh of Preferred Stock*Cost of Preferred Stock + Weight of Common Equity*Cost of New Common Equity
Cost of Capital = 50%*9.6% + 30%*9% + 20%*11.2%
Cost of Capital = 9.74%

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