Determining the Weighted (Marginal) Cost of Capital Schedule - Financial Management

In the beginning of the chapter, the computation of the weighted (marginal) cost of capital was based on the assumption that the firm would get equity funds only from internal sources, that all debt had a single cost, and that all preferred stock had a single cost.

The procedure illustrated in that earlier discussion must be modified if the firm anticipates selling new common stock (having a higher component cost) or issuing additional increments of debt securities at successively higher costs to finance its capital budget.

Marginal Cost of Capital Examples

To illustrate, suppose the Major Foods Corporation is developing its capital expenditure plans for the coming year. The company’s schedule of potential capital expenditure projects for next year is as follows:

These projects are closely related to the company’s present business and have the same degree of risk as its existing assets. The firm’s current capital structure (as well as its targeted future capital structure) consists of 40 percent debt, 10 percent preferred stock, and 50 percent common equity measured on the basis of the current market value of debt, preferred stock, and equity in the capital structure.

Table shows the current balance sheet for Major Foods. Major Foods can raise up to $5 million in debt funds at a pretax cost of 9 percent; debt amounts exceeding$5 million will cost 10 percent. Preferred stock can be sold at an after-tax cost of 10 percent. Major Foods’ marginal tax rate is 40 percent.

Major Foods expects to generate $10 million of retained earnings over the coming year. Its present dividend rate, D0, is$2 per share. The firm’s common stock is now selling at $25 per share, and new common stock can be sold to net the firm$24 per share.

Balance Sheet for Major Foods (in Millions of Dollars)

Over the past several years,Major Foods’ earnings and dividends have grown at an average of 7 percent per year, and this growth rate is expected to continue for the foreseeable future. The company’s dividend payout ratio has been, and is expected to remain, more or less constant.

Given this information,Major Foods’weighted (marginal) cost of capital can be calculated for the coming year:

• Step 1: Calculate the cost of capital for each individual component—the cost of debt, the cost of preferred stock, and the cost of equity.
Cost of debt:
ki = kd(1 – T) = 9.0