Use the following information to answer the question below.
CDE Inc.'s current (and optimal) capital structure is 40% debt, 10% preferred stock, and 50% common equity. CDE is in the 40% tax bracket. The company can issue up to $20,000,000 in new bonds at par with a 7% coupon; any subsequent amount must carry a 2% premium to compensate investors for added risk. A new issue of preferred stock would pay an annual dividend of $4.00 and be priced to net the company $50.00 per share after the $3.00 per share floatation cost. The firm has $21,000,000 in retained earnings. CDE's common stock trades at $40.00 per share and the expected dividend on the common stock is 2.00. Floatation costs on common equity issues is $5.00 per share. The company is growing at 7% per year.
-What is the marginal cost of capital (MCC) break point for common equity?
A) $20,000,000
B) $12,000,000
C) $42,000,000
D) $50,000,000

Question

Quizplus · Accepted Answer

The marginal cost of capital (MCC) break point for common equity is calculated based on the amount of retained earnings available, as this is the amount of equity financing that can be used before the company must resort to new equity, which has a higher cost due to flotation costs. The break point for common equity is calculated as the amount of retained earnings divided by the percentage of common equity in the capital structure. In this case, CDE Inc. has $21,000,000 in retained earnings and common equity represents 50% of the capital structure. Therefore, the break point for common equity is $21,000,000 / 0.50 = $42,000,000.

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