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Marginal Cost of Capital

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Chapter 1 - 5 Chapter 6 - 10 Chapter 11 - 15 Chapter 16 - 17

11. Corporate Finance 11.8 Marginal Cost of Capital

12. Securities Markets 11.9 Factors Affecting the Cost of Capital

13. Equity Investments 11.10 Payback Period

14. Fixed Income Investments 11.11 Net Present Value (NPV) and the Internal Rate of Return (IRR)

15. Derivatives 11.12 The NPV Profile

11.13 Cash Flow and NPV Applications

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost
of another unit of capital raised. As more capital is raised, the marginal cost of capital rises. Frequently Asked Questions
With the weights and costs given in our previous example, we computed Newco's weighted average What is the difference between a capital good and a
cost of capital as follows: consumer good?

What is a derivative?
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12) What is an economic moat?

WACC = 0.084, or 8.4%

What's the difference between limited liability
partnership and general partnership?
We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will remain
unchanged as new debt, preferred stock and retained earnings are issued until the company's
retained earnings are depleted.

Example: Marginal Cost of Capital

Once retained earnings are depleted, Newco decides
to access the capital markets to raise new equity. As
in our previous example for Newco, assume the
company's stock is selling for $40, its expected ROE is
10%, next year's dividend is $2.00 and the company
expects to pay out 30% of its earnings. Additionally,
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assume the company has a flotation cost of 5%.
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Interest Rate Starting @8.6%. Newco's cost of new equity (kc) is thus 12.3%, as
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calculated below: Trading Center

kc = 2 + 0.07 = 0.123, or 12.3%

40(1-0.05)

Answer:
Using this new cost of equity, we can determine the WACC as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) Partner Links

WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123) Learn to trade stocks by investing $100,000 virtual
WACC = 0.086, or 8.6% dollars...

The WACC has been stepped up from 8.4% to 8.6% given Newco's need to raise new equity.

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Figure 11.1
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At some point, as the company continues to raise capital, the MCC can be higher than the WACC.

MCC Vs. WACC

The marginal cost of capital is simply the weighted average cost of the last dollar of capital raised. As
mentioned previously, in making capital decisions, a company keeps with a target capital structure.
There comes a point, however, when retained earnings have been depleted and new common stock
has to be used. When this occurs, the company's cost of capital increases. This is known as the
"breakpoint" and can be calculated as follows:

Formula 11.9

Breakpoint for retained earnings = retained earnings

wce

Example:

For Newco, assume we expect it to earn $50 million next year. As mentioned in our previous
examples, Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost curve, if
we assume wce = 55%?

Answer:
Newco's breakpoint = $50 million (1-0.3) = $63.6 million
0.55

Thus, after Newco raises roughly $64 million of total capital, new common equity will need to be
issued and Newco's WACC will increase to 8.6%.

Factors that affect the cost of capital can be categorized as those that are controlled by the company
and those that are not.

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Next: Factors Affecting the Cost of Capital

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