Marginal Cost of Capital (MCC) is the weighted average cost of capital for the last dollar raised in new capital. MCC of the company remains constant for some time after which it increases. This depends on the amount of additional capital raised and eventually increases as the cost of raising new capital is higher due to flotation cost. This is mostly evident in case of
Marginal cost of capital is calculated as below:
Proportion of debt in the target capital structure “
Proportion of
Proportion of common equity in the target capital structure “
After tax cost of debt, preferred stock, retained earnings and new equity is “
Breakpoint of retained earnings is the maximum amount of fund that can be raised without issuing new common equity, since the equity portion of the new capital can be met through retained earnings.
There are two independent projects S and L. They have a cost of $150,000 and $140,000 respectively, with an IRR of 12% and 10%. The company’s capital structure consists of 20% debt and 80% common equity. After tax cost of debt, cost of retained earnings and cost of new common equity are 4%,10%,12.5% respectively. The company expects to generate $230,000 in retained earnings.
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Check out a sample textbook solution- Lane Industries is considering three independent projects, each of which requires a $2.8 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Cost of capital = 12% IRR = 14% Project M (medium risk): Cost of capital = 9% IRR = 7% Project L (low risk): Cost of capital = 6% IRR = 7% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $3,900,000. If Lane establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places. %arrow_forwardWalsh Company is considering three independent projects,each of which requires a $4 million investment. The estimated internal rate of return (IRR)and cost of capital for these projects are presented here:Project H (high risk): Cost of capital = 16% IRR = 19%Project M (medium risk): Cost of capital = 12% IRR = 13%Project L (low risk): Cost of capital = 9% IRR = 8%Note that the projects’ costs of capital vary because the projects have different levels ofrisk. The company’s optimal capital structure calls for 40% debt and 60% common equity,and it expects to have net income of $7,500,000. If Walsh establishes its dividends from theresidual dividend model, what will be its payout ratio?arrow_forwardWalsh Company is considering three independent projects, each of which requires a $3 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented below: Project H (High risk): Cost of capital = 16% IRR = 19% Project M (Medium risk): Cost of capital = 13% IRR = 11% Project L (Low risk): Cost of capital = 8% IRR = 9% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 30% debt and 70% common equity, and it expects to have net income of $7,268,000. The data has been collected in the Microsoft Excel Online file below . Open the spreadsheet and perform the required analysis to answer the question below. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places.arrow_forward
- Walsh Company is considering three independent projects, each of which requires a $4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Cost of capital = 16% IRR = 18% Project M (medium risk): Cost of capital = 13% IRR = 12% Project L (low risk): Cost of capital = 7% IRR = 10% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 35% debt and 65% common equity, and it expects to have net income of $7,154,000. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio?arrow_forwardWalsh Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Project M (medium risk): Cost of capital = 15% Cost of capital = 13% Project L (low risk): Cost of capital = 7% IRR = 8% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 35% debt and 65% common equity, and it expects to have net income of $11,329,500. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places. % IRR = 22% IRR = 12%arrow_forwardLane Industries is considering three independent projects, each of which requires a $2.4 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are the following: Project H (high risk): Cost of capital = 14% IRR = 16% Project M (medium risk): Cost of capital = 9% IRR = 7% Project L (low risk): Cost of capital = 9% IRR = 10% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 40% debt and 60% common equity, and it expects to have net income of $4,200,000. If Lane establishes its dividends from the residual dividend model, what will be its payout ratio?arrow_forward
- The Welch Company is considering three independent projects, each of which requires a $5 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are as follows: Project H (high risk): Cost of capital = 16%; IRR = 20% Project M (medium risk): Cost of capital = 12%; IRR = 10% Project L (low risk): Cost of capital = 8%; IRR = 9% Note that the projects’ cost of capital varies because the projects have different levels of risk. The company’s optimal capital structure calls for 50% debt and 50% common equity. Welch expects to have net income of $7,287,500. If Welch bases its dividends on the residual model (all distributions are in the form of dividends), what will its payout ratio be?arrow_forwardWalsh Company is considering three independent projects, each of which requires a $3 million investment. The estimated internal rate of return (IRR) and cost of capital for these projects are presented here: Project H (high risk): Cost of capital = 17% Project M (medium risk): Cost of capital = 15% Project L (low risk): Cost of capital = 7% Note that the projects' costs of capital vary because the projects have different levels of risk. The company's optimal capital structure calls for 45% debt and 55% common equity, and it expects to have net income of $14,800,500. If Walsh establishes its dividends from the residual dividend model, what will be its payout ratio? Round your answer to two decimal places. IRR = 21% IRR = 12% IRR = 8% LO (Ctrl) -arrow_forwardThe Emu Manufacturing Company is considering five independent investment opportunities. The required investment outlays and expected internal rates of return (IRR) for these investments are shown below. The firm's cost of capital is 14% and its target optimal capital structure is a debt ratio of 30%. Internally generated funds totalling $900,000 are available for all investment opportunities. (i) Based on the IRR method, which investment(s) should be accepted? (ii) If the company were to undertake all acceptable investments, what amount should be paid out in dividends according to the residual dividend policy? (iii) What would be the amount of external finance required if the company were to undertake all acceptable investments?arrow_forward
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