Question

The management of a conservative firm has adopted a policy of never letting debt exceed

30 percent of total financing. The firm will earn $10,000,000 but distribute 40 percent

in dividends, so the firm will have $6,000,000 to add to retained earnings. Currently

the price of the firm’s stock is $50; the company pays a $2 per share dividend, which is

expected to grow annually at 10 percent. If the company sells new shares, the net to the

company will be $48 (i.e., the flotation costs of issuing new shares is $2 per share).

The rate of interest on the firm’s long-term debt is 10 percent and the firm is in the 32

percent income tax bracket. If the firm issues more than $2,400,000 in debt, the interest

rate will rise to 11 percent.

The firm raises funds in increments of $3,000,000 consisting of $900,000 in debt and

$2,100,000 in equity. This strategy maintains the capital structure of 30 percent debt

and 70 percent equity. The cost of retained earnings= 14.40%

The cost of issuing new common stock = 14.58%

The cost of debt for the first $2,400,000 = 6.8%

The cost of debt in excess of $2,400,000 = 7.48%

Develop the marginal cost of capital schedule through $12,000,000. In

other words, find the weighted average cost of capital for all levels of financing up

to $12,000,000 (ON EXCEL)

Answer 1