Unit 3 Intellipath Notes Marginal Cost of Capital

.docx

School

Colorado Technical University *

*We aren’t endorsed by this school

Course

615

Subject

Finance

Date

Jan 9, 2024

Type

docx

Pages

Uploaded by SuperHumanFog12992

Introduction The cost of accessing capital can vary. This was the reason for exploring the concept of weighted average cost of capital (WACC) as well as considering it one appropriate decision-making benchmark for new projects. The marginal cost of capital (MCC) is the cost of the most recent dollar of capital raised and will contribute to the WACC. Generally, it is understood that as more capital is raised, the marginal cost of capital increases. The increase in the MCC is largely a result of increased risk and the risk-reward return tradeoff required by stakeholders. Learning Materials Additional Equity Scenario Generally, a company accesses capital by using funds from retained earnings, debt or equity. The company has a target capital structure that ensures a balanced approach needed to maintain stable financial performance. The firm has used up other sources of capital, such as retained earnings, and does not want to take on new debt. The CFO has now determined the next best step would be to raise money in the capital markets by issuing new common stock. The cost of equity (R s ) for the new stock issue could be found using the capital asset pricing model (CAPM). Assuming that the current 10-year Treasury bond rate is 3 percent, β for COE Logistics is 1.4, and the current return on the broader market is 10 percent. Current rates on the 10-year Treasury bond, at any point in time, can be found on Bloomberg.com. R s = 3 + 1.4 (10 – 3) = 12.8% Marginal Cost of Capital (MCC) In the instance of a new stock issue, the marginal cost of capital (MCC) is equal to the cost of equity. Therefore, the MCC of the newly stock issued is 12.8 percent. In the case of debt, the MCC is equivalent to the contractual costs incurred, such as interest payments or fees.

It is important to note that because the MCC of 12.8 percent is above the company’s previously calculated WACC of 9.48 percent, the new stock issue will cause an increase in the WACC. The CFO will need to carefully consider the effects of this MCC. Ideally, the CFO should seek out methods of raising capital that are below the existing WACC or investments and projects that could potentially offset the higher MCC required to access more capital. The increase in the WACC can impact other operational decisions related to projects. It can also change stakeholders’ view of the firm as an ongoing concern. Ultimately, when there is upward pressure on the WACC, a CFO looks for internal opportunities and external factors to influence the WACC. Operational changes in the way projects influence the WACC and revisions in dividend policy and investment policy are internal factors that impact the WACC. External factors influencing the WACC include interest rates and tax policy. Summary The cost of the most recent dollar of capital raised is called the marginal cost of capital (MCC). After the new capital has been raised, the MCC will be blended with the previous weighted average cost of capital (WACC) to arrive at a new WACC for the firm. Raising capital with an MCC above the WACC will increase the overall WACC, whereas raising capital with an MCC below the existing WACC will lower the overall WACC. As a result, the MCC can impact what projects are chosen and what other investments are deemed suitable for the firm. Q: A marginal cost of capital (MCC) above the weighted average cost of capital (WACC) will ____. A: cause the WACC to be revised higher X close the company’s bank accounts X cause investors to sell their stock X reduce the overall borrowing costs of the firm Q: A marginal cost of capital below the existing WACC for Apex will cause a(n) ____ in the WACC. A: decrease Q: A marginal cost of capital above the existing WACC for Apex will cause a(n) ____ in the WACC. A: increase

Q: A change in which factors could impact the MCC for a new stock issue by Apex? A: beta X a new CEO X reduction in gross profit margin X cash-on-hand Q: Which of the following is a piece of information you would need to determine the MCC for a new stock issue by Apex? A: return on the market A: beta X cash flow X annual revenue X plant depreciation X cost of goods sold Q: AS the newly hired VP of finance, you report to the CFO. In this capacity, your responsibilities include preparation of financial statements, comparative analysis and benchmarking to sector performance, and the assessment of new business investment opportunities to grow Apex’s expansion endeavors in a challenging market. Mary asks you to handle a meeting with the board about the significance of the marginal cost of capital (MCC). Which of the following are important issues with respect to the MCC? A: it is equivalent to the investors’ required return for the new stock issue A: changes may be needed in investment and dividend policy X loan payments will increase X it will increase current liabilities X less cash will be available for operational purposes X Apex’s tax liability will increase Q: Which of the following is true of the Marginal Cost of Capital (MCC)? A: MCC of capital raised using debt is the sum of contractual obligations such as interest payments and fees.

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version