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

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.

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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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