Question

The Nolan Corporation finds that it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 35 percent debt, 10 percent preferred stock, and 55 percent common equity. Initially common equity will be in the form of retained earnings (K_e) and then new common stock (K_n). The costs of the various sources of financing are as follows: debt, 5.6 percent; preferred stock, 11 percent; retained earnings, 8 percent; and new common stock, 9.2 percent.

a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, K_e.) (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Weighted average cost of capital             %

b. If the firm has $11 million in retained earnings, at what size of investment will the firm run out of retained earnings? (Enter the answer in millions.)

Capital structure size (X)           $  million

c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 55 percent of the capital structure, but it will all be in the form of new common stock, K_n.) (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Marginal cost of capital             %

d. The 5.6 percent cost of debt referred to above applies only to the first $14 million of debt. After that the cost of debt will be 7.6 percent. At what size of investment will there be a change in the cost of debt? (Enter the answer in millions.)

Capital structure size (Z)           $  million

e. What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts c and d.) (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Marginal cost of capital             %

Answer 1

Please note that there is no mention of tax rate in the entire question. And because of this, all our analysis and calculation will be restricted to pre tax Weighted average cost of capital (WACC)

Part (a)

Element	Proportion (A)	Cost (B)	Element Cost (A x B)
Debt	35%	5.60%	1.96%
Preferred stock	10%	11%	1.10%
Common equity (in the form of retained earnings)	55%	8%	4.40%
WACC			7.46%

Part (b)

Capital structure size (X) = Retained Earnings / Proportion of retained earnings in capital structure = 11 / 55% = $ 20 million

Part (c)

Element	Proportion (A)	Cost (B)	Element Cost (A x B)
Debt	35%	5.60%	1.96%
Preferred stock	10%	11.00%	1.10%
Common equity (in the form of new equity)	55%	9.20%	5.06%
WACC			8.12%

Part (d)

Capital structure size (Z) = Debt limit / proportion of debt in capital structure = 14 / 35% = $ 40 million

Part (e)

Element	Proportion (A)	Cost (B)	Element Cost (A x B)
Debt (Expensive debt)	35%	7.60%	2.66%
Preferred stock	10%	11.00%	1.10%
Common equity (in the form of new equity)	55%	9.20%	5.06%
WACC			8.82%