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Assignment1 FM

1) The initial weighted average cost of capital is 7.4% for debt, 10% for preferred stock, 13% for retained earnings, and 55% equity. 2) The firm will run out of $27.5 million in retained earnings at a capital structure size of $50 million. 3) After that point, the marginal cost of capital will be 11.16% as equity will be in the form of new common stock with a cost of 14%.

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71 views4 pages

Assignment1 FM

1) The initial weighted average cost of capital is 7.4% for debt, 10% for preferred stock, 13% for retained earnings, and 55% equity. 2) The firm will run out of $27.5 million in retained earnings at a capital structure size of $50 million. 3) After that point, the marginal cost of capital will be 11.16% as equity will be in the form of new common stock with a cost of 14%.

Uploaded by

Abdifatah Abdilahi
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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QUESTION ONE (1)

Bosworth Petroleum needs $500,000 to take a cash discount of 2/10, net 70. A banker willloan the
money for 60 days at an interest cost of $8,100.
A. What is the effective rate on the bank loan?
B. How much would it cost (in percentage terms) if Bosworth did not take the cash discount, but paid
the bill in 70 days instead of 10 days?
C. Should Bosworth borrows the money to take the discount?
D. If the banker requires a 20 percent compensating balance, how much must Bosworth borrow to end
up with the $500,000?
E. What would be the effective interest rate in part (D) if the interest charge for 60 days were
$13,000? Should Bosworth borrow with the 20 percent compensating balance? (There are no funds to
count against the compensating balance requirement.)
SOLUTION:-

A. Effective rate of interest = $ 8,100 x 360 = 1.62% x 6= 9.72%


$ 500,000 60

B. Cost of lost discount= 2% x 360 = 2.04% x 6= 12.24%


98% (70 – 10)

C. Yes, because the cost of borrowing is less than the cost of losing the discount

D. 500,000
(1 - C)

= 500,000
(1 - 0.2)

= $ 500,000
0.8
= $ 625,000

E. Effective interest rate = $ 13,000 x 360


$ 625,000 – 125,000 60

= 13,000 x 6
500,000

= 2.6% x 6 = 15.6%

: - No, don’t borrow with a compensating balance of 20 percent since the effectives
rate is greater than the saving from taking the trade discount
QUESTION 2
The Kerban Corporation finds that it is necessary to determine its cost of capital. Kerban
current capital structure calls for 40 percent debt, 5 percent preferred stock, and 55 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, 7.4 percent; preferred stock, 10 percent; retained earnings, 13 percent; and new
common stock, 14 percent.

A. What is the initial weighted average cost of capital? (Include debt, preferred stock, and
common equity in the form of retained earnings, (Ke.)

B. If the firm has $27.5 million in retained earnings; at what size capital structure will the
firm run out of retained earnings?

C. What will the marginal cost of capital be immediately after that point? (Equity will remain
at 55 percent of the capital structure, but will all be in the form of new common stock, Kn.)

D. The 7.4% cost of debt referred to above applies only to the first 32million of debt. After
that the cost of debt will be 8.6 percent. At what size capital structure will there be a change
in the cost of debt?

E, what will the marginal cost of capital is immediately after that point? (Consider the facts
in both parts c and d.)

Solution
From the given data:
Capital structure:
Debt: 40%
Preferred stock  : 5%
Common equity: 55%  

Cost of capital:
Debt: 7.4%
Preferred stock: 10%
Retained earnings: 13%
New common stock: 14%

A. Calculation of weighted average cost of capital is as below:


B. Z = Retained Earning
% of retained earning with in capital structure

= 27.5 million
0.55
= 50Million (50,000,000)

C. MARGINAL COST OF CAPITAL.

COST WEIGHTED WEIGHTED


COST
DEBT 7.4 % 40 % 7.4% x 0.4%
= 2.96 %
PREFRRED 10 % 5% 10% x 0.05%
STOCK = 0.5 %

NEW 14 % 55 % 14% x 0.55%


COMMON = 7.7 %
STOCK

MARGINAL COST OF CAPITAL = 11.16 %

D. Z =Amount of borrower cost debts


% of debt with in capital structure
= 32 million
0.4 %

= 80 Million ($ 80,000,000)

E. CALCULATE THE MARGINAL COST OF CAPITAL.

COST WEIGHTED WEIGHTED


COST
DEBT 8.6 % 40 % 8.6% x 0.4%
= 3.44%
PREFERED 10 % 5% 10% x 0.05%
STOCK
= 0.5 %
NEW COMAN 14 % 55 % 14% x 0.55%
STOCK = 7.7 %

MARGINAL COST OF CAPITAL = 11.64 %

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