Chapter 11, Problem 19PROB

Summary Introduction

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 cost of equity, where first the retained earnings are utilized by the firms to meet their target capital structure and any excess fund required is raised through new equity. So, as new equity is added to the fund, the marginal cost of raising the fund also increases.

Marginal cost of capital is calculated as below:

$MCC=w_d\left(r_{dT}\right)+w_{ps}\left(r_{ps}\right)+w_s\left(r_{s}or{r}_e\right)$

Proportion of debt in the target capital structure “$w_d$”

Proportion of preferred stock in the target capital structure “$w_{ps}$”

Proportion of common equity in the target capital structure “$w_s$”

After tax cost of debt, preferred stock, retained earnings and new equity is “$r_{dT}$”,“$r_{ps}$”,“$r_s$”and “$r_e$”, respectively.

Breakpoint is the value of the new capital that can be raised just before an increase in the firm’s weighted average cost of capital.

$Break-po\mathrm{int}=\frac{\left(\begin{array}{l}\text{Maximum amount of lower cost }\\ \text{of capital of a given type}\end{array}\right)}{\left(\text{Proportion of that type of capitalinthecapitalstructure}\right)}$

The company is evaluating four independent projects, each having the cost of $214,000. IRR for project 1,2,3 and 4 are 19%,15%,18%,14%. WACC is 11% up to $520,000, 12.5% from $520,000-745,000 and increases to 15.2% when above $745,000