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 3: The 9.6% cost of debt applies only to the first $29 million of debt. After that, the cost of debt will be 11.2%. At what size capital structure will there be a change in the cost of debt? What will the marginal cost of capital be immediately after that point? (Consider the facts in both Part 2 and Part 3 in your computations.)

Select one:

a. $58 million, 10.54%

b. $72 million, 12.2%

c. $62 million, 9.24%

d. $62 million, 9.24%

e. $54 million, 10.7%

f. $58 million, 7.89%

Explanation / Answer

Debt Preferred Stock Common Equity

50% 30% 20%

$29 million the cost of debt will change from 9.6% to 11.2%. So maximum capital structure beyond which there will be change in cost of debt is X (say):

50% of X = $29 million

X = 29 * 2 = $58 million.

Marhginal cost of capital (MACC) will be more than cost of debt which is 9.6% because MACC is the weighted average of cost of various sources of financing and cost of debt is lowest. Given option sit should be 10.54%.

So answer is (a.)

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