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# Marginal cost of capital (MCC) above and below break point

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A company has been growing at a constant rate of 8% a year. Its retained earnings for the year are \$16 million, common stock is selling for \$60, and the current debt to assets ratio is 35%. The company can raise up to \$18 million in debt at 8%. A 12% interest will apply if the amount exceeds \$18 million. New common stock yields the firm \$45. The required rate of return on retained earnings is 12%.The tax rate is 40%. Calculate the marginal cost of capital (WACC) above and below the break points in the MCC schedule.

#### Solution Preview

Debt to asset ratio=35%
Equity to asset ratio = 1-35%=65%
Debt equity ratio =35%/65%=0.5385
Cost of debt when debt is less than 18 million = Interest rate *(1-Tax Rate)
=8%*(1-40%)=4.8%
Cost of debt when debt is more than 18 million = Interest rate *(1-Tax Rate)
=12%*(1-40%)=7.2%
Cost of retained earnings (internal equity) = 12%
Retained earnings = 16 million
Floatation cost of new equity =\$60-\$45=\$15
Floatation cost of new equity in % ...

#### Solution Summary

Illustrates the concept of marginal cost of capital and how the firm's marginal cost of capital changes with changes in its financing requirements.

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## Strident Marks: Calculate cost of capital, IRR, WACC, MCC. Rank investments

Scenario
You are a financial analyst in the finance division of Strident Marks, a manufacturer of athletic equipment and apparel, which has recently gone through the initial public offering (IPO) process and has become a public company. Strident Marks has annual sales revenue of approximately \$50 million and makes seven unique and distinct products (which serve seven different markets). Each product is represented by its own division within the company and has its own group of sales, marketing, and manufacturing personnel. Some departments, including human resources and the finance division, support the entire organization. Operations consist of a single headquarters and production (manufacturing) center.

In your role as financial analyst you are responsible for compiling and reporting on budget / forecast data, for assisting your investor relations department, and for assessing and valuing new business opportunities (which will ultimately be presented to upper management). You report directly to the Chief Financial Officer (CFO) and have the use of the accounting department's staff accountants to assist you with your budget / forecast responsibilities.

You have been informed by the CFO that Strident Marks will be aggressively pursuing new business opportunities, which may include expansion through acquisition and the development and implementation of new products. As a publicly traded company, Strident Marks is scrutinized by bankers and investors as never before. In fulfilling your responsibilities you must keep this in mind, and you must instill a new sense of financial discipline in the organization.

What does a company's cost of capital represent and how is it calculated? How do market rates and the company's perceived market risk impact its cost of capital, and how does the company's debt to equity mix impact this cost of capital? Using the information provided, develop a spreadsheet to calculate weighted average cost (WAC) and marginal weighted average cost (MCC) of capital for Strident Marks?

You have developed the following table concerning the cost of capital sources for Strident Marks:

Source of capital
After tax cost

Long term debt
6%

Preferred stock
18%

Common stock equity
20%

Strident Marks capital structure weights used to calculate its WACC are:

Source of Capital After Tax Cost Amount Available After tax cost, After Break Point
Long-term debt 6% 200,000 12%
Preferred stock 18% 100,000 25%
Common stock equity 20% 200,000 40%

The future investment opportunities and the corresponding Internal Rate of Return (IRR) follow. As a result of operating its business operations profitably, Strident Marks has \$1,000,000 to invest. Considering Strident Marks' weighted average cost of capital and MCC, rank the investment opportunities and indicate which ones would be accepted, which (if any) would be rejected and why.

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