Mercer Electronics is determining the marginal cost of capital. The 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 (Ke) and then new common stock (Kn). The costs of the various sources of financing are as follows: debt, 9.6 percent; preferred stock, 9 percent; retained earnings, 10 percent; and new common stock, 11.4 percent.
Use this information to answer the next 3 quiz questions:
1) What is the initial WACC?
2) If the firm has $28.5 million in retained earnings, at what size capital structure will the firm run out of retained earnings? What will be the marginal cost of capital immediately after that point? (Equity will remain at 30% in the capital structure, but will all be in the form of new common stock.)
3) The 9.6% cost of debt referred to earlier applies only to the first $30 million of debt. After that, the cost of debt will be 11.2%. At what size capital structure will there be a change in the cost of debt? What will be the marginal cost of capital immediately after that point? Consider information from parts 2 and 3.