CFA Level ICorporate IssuersHard
Harbor Manufacturing has $2,000,000 of retained earnings available for equity financing at a cost of 10%. Once retained earnings are exhausted, the firm must issue new common equity at a higher cost of 12%. Harbor's target capital structure is 60% equity and 40% debt. At what total capital budget level will Harbor experience a break point requiring the use of more expensive new equity?
- A$3,333,333
- B$2,400,000
- C$2,000,000
- D$3,000,000
Show answer & explanationAnswer & explanation
Correct answer: A. $3,333,333
Break point = Amount of lower-cost capital available / Weight of that capital source in the target structure = $2,000,000 / 0.60 = $3,333,333. Beyond this total capital budget, retained earnings are exhausted and the marginal cost of capital rises.
Why the other options are wrong
- B. Incorrectly multiplies rather than divides retained earnings by the equity weight.
- C. This is just the retained earnings amount, not the total budget break point.
- D. Does not correctly account for the equity weight in the capital structure.
Marginal Cost of Capital Break Point
The total amount of new capital at which the cost of one or more capital components increases, typically when retained earnings are exhausted and new equity must be issued.
- Break point = Amount of capital at old cost / Weight of that source in target structure
- Marginal cost of capital (MCC) schedule rises at each break point
- Firms should use MCC, not just WACC, for large capital budgets
Memory trick: Divide the cheap pool of cash by its weight to find where costs jump