The McGee Corporation finds it is necessary to determine its marginal cost of capital. McGee’s current capital structure calls for 40 percent debt, 30 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, 9.6 percent; preferred stock, 9.0 percent; retained earnings, 10.0 percent; and new common stock, 11.4 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.)

b. If the firm has \(28.5 million in retained earnings, at what size capital structure will the firm run out of retained earnings?

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.)

d. The 9.6 percent cost of debt referred to earlier applies only to the first \)30 million of debt. After that, the cost of debt will be 11.2 percent. At what size capital structure will there be a change in the cost of debt?

e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.)

Step by step solution

01

Definition of Capital Structure

The proportion of debt and equity in the company's capital is known as the capital structure. The company uses the debt-to-equity ratio to determine the risk associated with capital borrowings.

02

Weighted Average Cost of Capital

Particular	Cost of capital	Weight	The weighted average cost of capital
Debt	9.6%	40%	3.84%
Preferred stock	9%	30%	2.7%
Common equity	10%	30%	3%
Weighted average cost of capital	9.54%

03

Capital structure at which the firm will run out of retained earnings

$\begin{array}{c}\mathbf{X}\mathbf{=}\frac{\mathbf{R}\mathbf{e}\mathbf{t}\mathbf{a}\mathbf{i}\mathbf{n}\mathbf{e}\mathbf{d}\mathbf{e}\mathbf{a}\mathbf{r}\mathbf{n}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{s}}{\mathbf{W}\mathbf{e}\mathbf{i}\mathbf{g}\mathbf{h}\mathbf{t}\mathbf{o}\mathbf{f}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{m}\mathbf{o}\mathbf{n}\mathbf{e}\mathbf{q}\mathbf{u}\mathbf{i}\mathbf{t}\mathbf{y}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{28}\mathbf{.}\mathbf{5}\mathbf{m}\mathbf{i}\mathbf{l}\mathbf{l}\mathbf{i}\mathbf{o}\mathbf{n}}{\mathbf{0}\mathbf{.}\mathbf{30}}\\ \mathbf{=}\mathbf{\$}\mathbf{95}\mathbf{m}\mathbf{i}\mathbf{l}\mathbf{l}\mathbf{i}\mathbf{o}\mathbf{n}\end{array}$

04

Marginal cost of capital

Particular	Cost of capital	Weight	The weighted average cost of capital
Debt	9.6%	40%	3.84%
Preferred stock	9%	30%	2.7%
Common equity	11.4%	30%	3.42%
Marginal cost of capital	9.96%

05

Capital structure at which the cost of debt will change

$\begin{array}{c}\mathbf{X}\mathbf{=}\frac{\mathbf{A}\mathbf{m}\mathbf{o}\mathbf{u}\mathbf{n}\mathbf{t}\mathbf{o}\mathbf{f}\mathbf{d}\mathbf{e}\mathbf{b}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{a}\mathbf{p}\mathbf{i}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{s}\mathbf{t}\mathbf{r}\mathbf{u}\mathbf{c}\mathbf{t}\mathbf{u}\mathbf{r}\mathbf{e}}{\mathbf{W}\mathbf{e}\mathbf{i}\mathbf{g}\mathbf{h}\mathbf{t}\mathbf{e}\mathbf{d}\mathbf{o}\mathbf{f}\mathbf{d}\mathbf{e}\mathbf{b}\mathbf{t}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{30}\mathbf{m}\mathbf{i}\mathbf{l}\mathbf{l}\mathbf{i}\mathbf{o}\mathbf{n}}{\mathbf{0}\mathbf{.}\mathbf{40}}\\ \mathbf{=}\mathbf{\$}\mathbf{75}\mathbf{m}\mathbf{i}\mathbf{l}\mathbf{l}\mathbf{i}\mathbf{o}\mathbf{n}\mathbf{s}\end{array}$

06

Marginal cost of capital

Particular	Cost of capital	Weight	The weighted average cost of capital
Debt	11.2%	40%	4.48%
Preferred stock	9%	30%	2.7%
Common equity	11.4%	30%	3.42%
Marginal cost of capital	10.6%

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