Question

8-Cost of Capita Example: Calculating break points ni Corporaiine costs for the Omni Corporation is shown in the figure has a target capital structure of 60% of financing costs equity and 40% debt. The schedule below Schedule of Capital Costs for Omni Amount of New Deb Amount of New in millions $0 to $99 $100 to $199 $200 to $299 Afier-Tax Cast of Debr 4.296 4.6% 5.0% Equity (in millions) $0 to $199 $200 to $399 $400 to $599 Cost of Equity 6.5% 8.0% 9, 5% Calculate the break points for Omni Corporation and graph the marginal cost of capital schedule. Answer Omni will have a break point each time a component cost of capital changes, for a total of four break points. break point debe $100mm 100 million $250 million 0.4 $200 million 0.4 pointdebt >$200mm$500 million break point equiry $200mm00 mion $333 million 0.6 Eequiry >$400mm9400 milin $667 million following fgure shows Omni Corporation's WACC for the differetbreak poins WACC for Alternative Levels of Financing in millions) WACC 5.58% 5.74% 664% 6.80% Capital Equity (609%) Equity Cest ofDebt 4.2% 4.6% 4.6% 5.0% 5.0% Cost of Debt (40%) $50 $250 $333 $500 $30 $150 $200 $300 6.5% 6.5% 8.0% 8.09% 9.5% $20 $100 $133 200 0 5267 770% Page
I just don’t understand what is going on. Please help

Answer 1

Cost of fund/ Financial Cost:- It is nothing but the cost for a company to raise funds (be in term of debts or equity or combination for both). Its just like buying a stuff and paying a price for it. If you buy more good, you ll have to pay more for it. similarly, funds have a cost associate with it like cost of debt and cost of equity.

Capital Structure:- Every company has its own capital structure in term of debt and equity in general according to its need and industry to propel desired growth and keeping cost of fund minimum.

Now, lets understand what is Break Point for any corporation, it is the monetary value change of new capital (Debt or equity) that can be raised before an increase in the company's weighted average cost of capital.

Weighted Average Cost of Capital:- weight is being assigned to the class (debt and equity) of capital return in the capital structure. formula is

WACC = (COST OF DEBT * %age of DEBT IN COMPANY) + (COST OF EQUITY * %age of EQUITY IN THE COMPANY)

So, the conclusion from above solution can be derived as:

Omni corporation can raise $250 million in the form of debt at a cost of debt at 4.6%.

Omni corporation can raise $500 million in the form of debt at a cost of debt at 5.0%

Omni corporation can raise $333 million in the form of equity at a cost of debt of 8.0%

Omni corporation can raise $250 million in the form of debt at a cost of debt of 9.5%

Weighted Average Cost of Capital for Omni's Capital structure are as explained:

$50 million capital raise has 60% debt ($30 million) and 40% equity ($20 million) has WACC of 5.58% (using WACC formula stated above)

$250 million capital raise has 60% debt ($150 million) and 40% equity ($100 million) has WACC of 5.74% (using WACC formula stated above)

$333 million capital raise has 60% debt ($200 million) and 40% equity ($133 million) has WACC of 6.64% (using WACC formula stated above)