Question

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan's current capital structure calls for 35 percent debt, 20 percent preferred stock, and 45 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 (after-tax), 9.5 percent; preferred stock, 7 percent; retained earnings, 15 percent; and new common stock, 12.2 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 Preferred stock Common equity Weighted average cost of capital 0.00 % b. If the firm has $18 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

Answer 1

Given,

Weight of debt = 35% or 0.35

Weight of preferred stock = 20% or 0.20

Weight of common stock = 45% or 0.45

Cost of debt(after tax) = 9.5%

Cost of preferred stock = 7%

Cost of retained earnings = 15%

Cost of new common stock = 12.2%

Solution :-

OBC=AAB Cost weights weighted after tax) Cost Debt (ka) 9.5% 0.35 3.3254 Preferred Stock 7.0% 0.20 1.4 % 15 % 0.45 6.75%. Common equity (Retained earnings) Weighted average I cost of capital) - 11.48%. (b) Capital structure size (X) Retained weight of earnings retained earnings $ 18 million 0.45 $ 40 million

(c) O I B TC=AXB Cost Iweights weighted after tax) cost 9.5 % 0.35 3.325 % Debt (kd) Preferred stock New Common Stock 0.20 1.4% 7.0% 12.2% o.us 5.49 % marginal cost of capital 10.22% (d) Amount of lower Cost debt = $20 million Now, Capital Structure Size (x) - Amount of lower cost debt Weight of debt $ 21 million 0.35 - $ 60 million

- A B C = AXB Cost weights weighted after tax) Cost Debt 11.5% 0.35 14.025 Preferred Stock 7.0% 0.20 1.4% New Common stock 12.2% o.us 5.49% marginal Cost of Capital 10.92%