Wellington Gas has a target capital structure of 50% common equity, 40% debt, and 10% preferred stock. The cost of retained earnings is 16%, and the cost of new equity (external) is 16.7%. Wellington can sell debentures that will have an after-tax cost of 8.3% and the after-tax cost of preferred stock will be 11.9%. What is the marginal cost of capital before and after the break point?

Question

Quizplus · Accepted Answer

Before the break point, the cost of equity is the cost of retained earnings (16%). After the break point, the cost of equity is the cost of new equity (16.7%). The marginal cost of capital (MCC) can be calculated using the weighted average of the costs of each component of capital based on the target capital structure. Before the break point: MCC = (0.5 * 16%) + (0.4 * 8.3%) + (0.1 * 11.9%) = 12.51%. After the break point: MCC = (0.5 * 16.7%) + (0.4 * 8.3%) + (0.1 * 11.9%) = 12.86%.

Wellington Gas Has a Target Capital Structure of 50% Common