Company ABC has an optimal capital structure of 40% debt and 60% common equity.

Question

Company ABC has an optimal capital structure of 40% debt and 60% common equity. Assume that the debt break points occur at $36 million and $50 million, and that the common equity break point occurs at $45 million. The after tax cost of debt is 6%, 10%, and 14% as borrowing increases, and the cost of common equity is 15% if using retained earnings and 20% if using newly issued common stock. Prepare the marginal cost of capital schedule. Use the following information to determine the optimal capital budget for Company Z.

Explanation / Answer

Problem -1

Break point is when the capital is not available at cheaper rate and beyond that point cost of capital increases be it debt or equity.

Solution to the problem as below :

Marginal cost of capital Break Point Debt Equity Debt Equity Total Remarks 36 14.4 21.6 0.864 3.24           4.10 Break point for debt @ 6%, same cost for equity 45 18 27 1.08 5.4           6.48 Same cost for debt , break point for equity @ 20% cost 50 20 30 2 6           8.00 Break point for debt @ 10%, same cost for equity

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