Chapter 11, Problem 29P

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 $(K_e)$ and then new common stock $\left(K_n\right)$ . 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, $K_e$ .)

b. If the firm has $\text{\$28}\text{.5}$ 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, $K_n$ .)

d. The 9.6 percent cost of debt referred to earlier applies only to the first $\text{\$30}$ 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.)