The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital structure. ? a. What is the firm's cost of capital if it uses only retained earnings? b. What is the firm's cost of capital if it uses new equity? c. How much total financing may the firm have before the marginal cost of capital rises?
What will be an ideal response?
a.The cost of capital using retained earnings: (.35)(.08) + (.65)(.14) = 11.9%?b.The cost of capital using new equity: (.35)(.08) + (.65)(.149) = 12.485%Notice that the marginal cost of capital rises after the firm exhausts its retained earnings and must start using more expensive new equity.??c.The break-point in the marginal cost of capital schedule: $23,678/.65 = $36,428?The retained earnings can support up to $36,428 in total financing and still maintain the optimal combination of debt and equity financing. However, after $36,428 of total financing, the retained earnings are exhausted, and the firm must start using more expensive new equity.
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