Hi, I am having trouble understanding break points in cost of capital in following schweser question. Could anyone help please? Thank you. ---------- Stolzenbach Technologies has a target capital structure of 60 percent equity and 40 percent debt. The schedule of financing costs for the Stolzenbach is shown in the table below: Amt of NewDebt(in mil) || After-tax CostofDebt || Amt of NewEquity (in mil) || CostofEquity $0 to $199 || 4.5 percent || $0 to $299 || 7.5 percent $200 to $399 || 5.0 percent || $300 to $699 || 8.5 percent $400 to $599 || 5.5 percent || $700 to $999 || 9.5 percent Stolzenbach Technologies has breakpoints for raising additional financing at both: A) $400 million and $700 million. B) $500 million and $700 million. C) $500 million and $1,000 million. D) $200 million and $400 million. The answer given is C.
Answer is C? First Break point => when debt portion is $200. Total financing = 200/.4 = 500. Second break point => when debt portion = $400. Total financing = 400/.4 = 1000 Third break point => when equity portion = $300. Total financing = 300/.6 = 500 Fourth Break point => when equity = $700. Total financing = 700/.6 = 1167
Thanks. I got the calculation part. Following is schweser’s explanation to the answer which I could not understand. --------------------------------- The correct answer was C) $500 million and $1,000 million. Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints. ----------------------------------
there are 3 break points, 500, 1000, 1167. What part are you not clear about?
Can someone explain conceptually instead of just using a formula… I dont understand sumit_Kansal explanation… THANK YOU
It is just a step up structute of cost of capital, the financing slabs point out that if the company raises more capital the cost of capital increases in steps.Think in terms of tax rate slabs as income increases the slab rate also increases but tax rates do not change for income within the slab. This step up cost also shows that cost of capital do not increase in a continuous fashion but rather in discrete steps. Given the data we calculate these step points in marginal financing cost. Also think of these steps in practical terms, lets say a company has 100 million in equity and 0 debt. Company management likes to tap into debt market to raise capital for new project. If company issues 5 Million of debt, lets say the market risk for similar risk debt is 4% (for understanding purpose, we are assuming that market only looks at debt to equity ratio to determine the risk of debt) for 5M in debt, debt to equity is 5%. Later company mangement decided to issue 5.1 M in debt, debt to equity is not 5.1%. What will be cost of capital ? Most likely it will stay at 4%, because the added risk of just 0.1% in debt to equity is very little. Cost of debt will stay at 4% for some range, say market participants want extra premium if debt to equity is more than 10%, now the cost of debt range will be 0 to 10M @ 4% … and so on we can calculate further steps …