Penny's Budget Gourmet Restaurants has a current capital structure that is 70% equity, 20% debt, and 10% preferred stock. This is considered optimal. Penny is considering a $100 million capital budgeting project. Penny has estimated the following: After-tax cost of debt: 7.0%
Cost of preferred stock: 8.0%
Cost of internal equity: 13.0%
Cost of external equity: 15.0%
Penny expects to have $40 million of new retained earnings available to finance this project. What is Marion's cost of capital for this project?

Question

Quizplus · Accepted Answer

First, we need to calculate the weight of each source of financing:
Equity: 70%
Preferred stock: 10%
Debt: 20%

Then, we need to calculate the cost of each component of the capital structure:
After-tax cost of debt: 7.0%
Cost of preferred stock: 8.0%
Cost of internal equity: 13.0%
Cost of external equity: 15.0%

Next, we can calculate the cost of capital using the weighted average cost of capital (WACC) formula:

WACC = (E/Total) * Re + (PS/Total) * Rps + (D/Total) * Rd * (1 - T)

Where:
E = market value of equity
PS = market value of preferred stock
D = market value of debt
Re = cost of internal equity
Rps = cost of preferred stock
Rd = after-tax cost of debt
T = tax rate

Assuming that the market value of debt, preferred stock, and equity equals their book value, we can calculate the WACC as follows:

WACC = (0.7 * 13%) + (0.1 * 8%) + (0.2 * 7% * (1 - 0%))
WACC = 9.1%

This is the WACC for the current capital structure. However, Penny is considering a new project that will be financed with new retained earnings. Therefore, the new capital structure will be different, and we need to recalculate the WACC.

Assuming that Penny will finance the entire $100 million project with new retained earnings and that the market value of equity will increase by $100 million, we can calculate the new weights as follows:

Equity: ($100 million + current equity) / ($100 million + current equity + current debt + current preferred stock)
Equity: ($100 million + 0.7*V) / ($100 million + 0.7*V + 0.2*V + 0.1*V)
Equity: 0.749

Preferred stock: 0.10
Debt: 0.151

Where V is the current market value of equity:

V = E / 0.7
V = $100 million / 0.7
V = $142.86 million

Next, we can recalculate the WACC using the new weights and the same cost of capital components:

WACC = (0.749 * 15%) + (0.10 * 8%) + (0.151 * 7% * (1 - 0%))
WACC = 11.90%

Therefore, the cost of capital for the new project is 11.90%. The best choice is C.

Penny's Budget Gourmet Restaurants Has a Current Capital Structure That