Assume the following information: Type of Capital After-Tax Cost Proportion of C

Question

Assume the following information:

Type of Capital                           After-Tax Cost                          Proportion of Capital Structure

Debt                                                     5%                                                  20%

Common Equity-                                 11%                                                 80%

                 retained earnings

Common Equity-                                  14%

                 new issue

The firm expects to retain $160,000 in earnings this year to invest in capital budgeting projects.

1. If the firms's capital budget is expected to equal $190,000, what required rate of return, or marginal cost of capital, should be used when evaluating capital budgeting projects?

2. What is the WACC if the capital budget is expected to be $220,000?

Explanation / Answer

Hi,

Please find the answer as follows:

Part A:

Retained Earnings = 160000

Capital Budget Expected = 190000

80% of 190000 = 152000 (will be met through retained earnings of 160000)

20% of 190000 = 38000 (will be through debt)

Required Return or MCC = 11*(152000/190000) + 5*(38000/190000) = 9.8%

Part B:

Retained Earnings = 160000

Capital Budget Expected = 220000

80% of 220000 or 160000 whichever is less = 160000 (will be met through retained earnings of 160000)

20% of 220000 = 44000 (will be through debt)

Balance = 220000 - 160000 - 44000 = 16000 (will be through new equity)

WACC = 11*(160000/220000) + 5*(44000/220000) + 14*(16000/220000) = 10.02%

Thanks.

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