Three Ways to Present the Marginal Cost of Capital Author(s): Fred D. Arditti and Milford S.

Tysseland Source: Financial Management, Vol. 2, No. 2 (Summer, 1973), pp. 63-67 Published by: Blackwell Publishing on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665484 . Accessed: 04/10/2011 14:03
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WAYS TO THREE MARGINAL COST

THE PRESENT CAPITAL OF

FRED D. ARDITTI and MILFORD S. TYSSELAND

Drs. Arditti and Tysseland are both members of the Faculty of Finance, College of Business Administration, University of Florida at Gainesville. Dr. Arditti was previously with the University of California at Berkeley and the Rand Corporation. Dr. Tysseland was previously with the Ford Motor Company.

)rs Editc and members-atSome Associate I Textbooks, courses, explicitly recommend the of the Finan cial Management Assouse of marginal cost of and teachersinelementary large ciation have expres;sed interest in the use capital as the cut-off rate economics consistently r conveance erlei of Financial Manag, ql for conveyanceof for accepting for a teach that profits tutorial articles. Al projects tutorial articles. Alt gh we do not wish thou firm are at a maximum to preempt space b y a c (Grunewald and Nemmers commitmentto conwhen marginal cost equals on tinuous publication, appwearance this page [6, p. 337], Lindsay and of Arditti and Tysselarid, "Three Ways to Sametz [10, p. 192], marginal revenue. Many the Margin al Cost of Capital"sigPrather and Wert [13, p. Present teachers in finance, how* . ss present tutorial ar, . .,,nifies our willingnes to > present tutorial ar192], Van Horne [14, p. ever, neglect ever, principle r this i0 ~~tidcles tifes on a seleines b on a selective >asis. in the teaching of capital 91] and Weston and Brige Ed itor ~i~tor ~ham [15, p. 139]). Four budgeting. appear to implicitly endorse marginal cost of capital Perhaps this is partly because a firm's capital may as the cut-off rate (Archer and D'Ambrosio [2, p. be a mix of funds from a number of sources; debt, 196], Curran [5, p. 99], Johnson [8, p. 254] and preferred stock, common stock etc., at varying costs, Kent [9, p. 330]), while three appear to suggest use and, even if a firm's optimal capital mix is known, of an average cost of capital, (Bradley [3, p. 166], additional funds are not raised simultaneously in the same proportions. Then, to avoid the obviously Committee [4, p. 127] and Hunt, Williams and Donaldson [7, p. 461]). unsupportable position that the capital budgeting cut-off rate should be at the cost of debt this year The reason for use of marginal cost of capital as the cut-off rate is no doubt implicit in all of the because this is the year to raise debt, and at the texts: namely, to maximize the value of the common equity rate next year, because next year is the year to raise equity - some have used weighted average stock of the firm. However, it appears to the authors that it is desirable to demonstrate, positively, cost of capital. (For additional discussion of the use to students and financial practitioners alike, that of the weighted average cost of capital, see [1].) A cursory review of a dozen current textbooks the cut-off rate which serves to fulfill this objective confirms this. Our interpretation is that only five is, in general, the marginal and not the average cost

Summer 1973

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of capital rate. In short, we focus on an approach that is often used in the literature of financial research, but is somewhat neglected in finance textbooks. We will begin with the familiar type of explanation used in elementary economics; continue with a modification including present value, or discounted cash flows; then, proceed to a more formal mathematical proof.

An Economic (marginal costmarginal revenue) Approach

Perhaps the simplest way to explain the necessity for use of marginal cost of capital as the cut-off rate for accepting new projects is by means of marginal cost and marginal revenue curves. Consider that Exhibit 1 represents such a typical marginal cost-marginal revenue approach, except that instead of the familiar smooth curves we have discrete intervals. Dollars of investmentopportunities, projects, are given on the horizontal axis; marginal revenue (or rate of return on projects per unit of time, when consideringdiscounted cash flow approach, below) and both marginal and average cost of capital are given on the vertical axis. Note that through Project C, marginal cost of capital and average cost of capital are equal; thereafter, marginal cost of capital increases at discrete intervals and, of course,

average cost of capital also increases, but by lesser increments. Abbreviations used on Exhibit 1 are defined as follows: MR stands for marginal revenue; R of R for rate of return; MCC for marginal cost of capital; ACC for average cost of capital. If we are considering an instantaneous situation, the cut-off point for project selection should be either QO or Q1I One would probably be indifferent toward Project E, as it is expected to earn exactly its marginal cost. We shall assume here that Project E is actually accepted. Selection of Project F with cut-off at Q2, however, would definitely not be advisable as its marginal cost of funds is greater than its rate of return.

A Discounted Cash Flow Approach

When one turns to use of discounted cash flow in his explanations, especially with regard to the total effect on the firm's value of a bundle of projects yielding returns over several future periods, he has somewhat more difficulty. The authors will first use an intuitive approach for explaining Exhibit 1 in this light and then proceed to a more formal approach in the following section. If one cuts off at Q1, at the intersection of the Investment Opportunity curve with the marginal cost of capital curve, he will accept Project E and reject

Exhibit 1. Investment Opportunities, Marginal and Average Costs of Capital

MR (or ,R of R), MCC, ACC

A LB

I-.
--

M _____--

E .

Q2

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FinancialManagement

Project F. At this point, marginal cost of capital is MCCN. Looking at the effect on the value of the firm over time, in light of having accepted a capital budget composed of Projects A through E, the firm is better off by the sum of the net present values (NPV's) of the cash flows from Projects when discounted at the average (A+B+C+D+E), cost of capital, ACCk. We compute the total effect on the value of the firm by the use of ACCk at this point because this is the average cost of the bundle of funds which financed this bundle of projects. We do this even though we use MCCN for the cut-off rate. To repeat, the marginal cost of capital, at the particular point in the capital supply schedule, is used as the cut-off rate in evaluating each individual project by comparing it with the particular project's rate of return per unit of time. However, when assessing the effect of the acceptance of the entire capital budget upon the value of the firm, we use the average cost of capital: the average cost of all of the funds that financed the aggregate capital budget. This becomes more clear when viewed in terms of what would happen if we were to cut off at the average cost of capital rate. If we were to cut off at Q2 (using the average cost of capital as the cut-off rate) and accept Project F, its NPV, computed at ACCL, at that point, would be zero. However, now the NPV of Projects the previously accepted projects, (A+B+C+D+E), when discounted at ACCL, will be less than when their cash flows were discounted at ACCk, because ACCL is greater than ACCk. In order for Project F to be accepted, its return must be sufficiently higher than ACCL to offset the effect of the increase of the average cost of capital from ACCk to ACCL in discounting the cash flows from the bundle of projects previously accepted. Since the rate of return on Project F does not provide this increment, it should be rejected and the cut-off should be at QI. This is more precisely demonstrated in the following section.

income stream. sented by

This value could also be repre-

V = SO+D,

(2)

where SO is the market value of the firm's common stock at to, and D is the market value of its debt, assuming only two types of securities in its capital structure. For simplicity, our model is based on one period; the more general, n-period, case is straightforward to derive, but mathematically "messy" and thus not useful as a teaching tool. Our formulation is a variation of that set forth in [11], except that their income stream is a perpetuity and, of course, they assume a constant k. The firm is now confronted with the possibility of making an investment, I, which will provide an expected rate of return, r, so that the value of the firm may then be representedby Vi = [X +(1 + r)I]/(1 + kl), (3)

where k1 is the new average cost of capital, or discount rate, that capitalizes the expected income stream. The new value of the firm could also be represented by V1 = Ss + D? + I, (4)

where S? is the new market value of the old common stock, D? is the new market value of the old bonds and I could be either new stock or new debt, or both. Under what conditions will the offered investment, I, be accepted? Only if it will not diminish the value of the firm's common stock, namely, if the following condition is satisfied: S? > SO,or S? - S > 0. There must be some minimum rate of return, r, which the new investment, I, must return to satisfy this condition. (We follow here the usual "perfect capital markets" assumption. See, for example, [12].) Determination of this minimum rate of return will now be approached. First, subtract (2) from (4), providing the following: V1 - Vo = S? + D? + I - SD .

A Mathematical Approach
The market value of the firm at to may be represented by Vo = X/(1 + k), (1)

where X is an abbreviation for a future expected income stream, and ko is the firm's average cost of capital, or the discount rate used to capitalize this

Assuming that Do = D, because the risk characteristics of the new investment are not sufficiently different to change the value of the old

Summer 1973

65

bonds, dropping the offsetting D's, and then transferring I to the left side of the equation, xwe have

V-

Vo - I = s

- s

Howexver, in viewxof the condition

we cmav nowx state

S?

So> o0

V1 - Vo - I > 0,
or

V1

- Vo > ,

then k1 = ko, and w here this is so, r = k = ko, and the marginal cost of capital or cut-off rate, r, may be as low as kl, which also equals ko. If the nex investment, I, increases the risk characteristics of the firm's income stream, then kl>ko, and r must be greater than k1 (the nexC axerage cost of capital) by some increment. Moreover, the new asset must generate enough aiitioina/l income to raise the expected lretul'n on total assets from ko to kl. This increment is (Vo/l) (kl--ko). Perhaps this might be better illustrated by an example. GiCcn a situation wxhere ko = .145, k1 = .150, Vo = $1,000,000 and I = $100,000, what w\ould be the minimum r for I to be accepted? This may be computed by use of equation (6). Then Vo/ = 10; r> .15 + 10(.15 -.145); and r> .20,

as the equivalent inxestment criterion that a prospectixe project must meet in order to be judged acceptable. Substituting (3) for V1 and (1) for Vo, we now\ haxe

X + (l+r)l]/(l+k)

X/(+ko) > 1,

which may be written as X/(l+kl) X/(l+ko) + [(l+r)l]/(l+kl) we obtain > I.

After factoring out X/(l+ko),

[X/(l+ko)] I ( (l+ko)/(l+kl))-

1] +

[ (l+r)/(l+kl) ] I > 1.
Multiplying through by (1+kl) gives

X/(l+ko) [ (l+ko) - (l+k)

Recalling that Vo yields Vo[(l + ko)Dividing X/(l+ko)

] + (+r) I >(l+kl)

I.

is by definition equal to

(1 + k1)] +(1 +r)l > (Hkl)I.

through by I and simplifying we obtain

(Vo/l) [ko-k ] + ( +r)> (1+k ).

Finally, solving for r gives

which is also the marginal cost of capital. Note that the firm must earn more than .15 on this new investment of I dollars, because in addition it must earn an amount large enough to bring the expected rate of return on total investment up from .145 to .15. In this case, for each dollar invested in I, there are 10 dollars of old investments, each expected to earn .145. Therefore, the extra amount to be earned above .15 by each dollar of I is .05, since .005 of this amount, figuratively speaking, can then be imputed to returns from prexiously existing assets. Further, it is readily shown from this illustration in the context of the model set forth herein, that the acceptance of I at an expected rate of return of 15 %/ would diminish the value of the firm. Recalling that to prevent common stock price from falling, xve must haxe V1 > Vo + I. Since Vo + I e can write V1 > $1,100,000. is equal to $1,100,000 But at a 15',' expected rate of return on I (i.e., setting r = .15 in equation (3)) wc obtain V1 = [(1.145) (1,000,000) 1.15 = 1,095,652, + (1.15) (100,000) 1/

r > k1 + (Vo/I) [k1 -koj.

(6)

At this point we should consider the content and meaning of equation (6). kl wxas defined under (3) as the new\ average cost of capital; r, as defined under (3) also, was the minimum rate of return required on investment I-the cut-off rate or marginal cost of capital. From equation (6), r is obviously greater than k1 by some increment if k1 >ko. If the new investment, I, does not change the risk characteristics of the firm's income stream,

where for X in (3) we substituted (l+ko) * V = (1.145) (1,000,000). Consequently, the V1 we obtain is less than that required (1,100,000) to prevent common stock xalue from falling. When weighted with the old ko, it is readily seen that this required r of .20 gives the new kl, and therefore r must be the marginal cost of capital:

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Financial Management

Amount $ 1,000,000 100,000

Weight .909 .091

Cost .145 .200

Weighted Average .1318 .0182 .1500 (=k 1)

Thus, the additional project, if it returns only the new average cost of capital, (kl), should be re-

jected, whereas if it returns the marginal cost of capital, (in this case, .20), it should be accepted. Since there is general agreement that all actions of the firm should be consistent with the maximization of market equity value, wouldn't it be better to derive and explain the cost of capital, or investment decision cut-off rate, as a direct consequence of this maximization principle? This is what'we have tried to do.

REFERENCES
1. Fred D. Arditti, "The Weighted Average Cost of Capital: Some Questions on Its Definition, Interpretation and Use", Journal of Finance (September 1973). 2. Stephen H. Archer and Charles A. D'Ambrosio, Business Finance, Theory and Management, New York, The Macmillan Company, 1972, 2nd edition. 8. Robert W. Johnson, Financial Management, Boston, Allyn and Bacon, Inc., 1957, 4th edition. 9. Raymond P. Kent, Corporate Financial Management, Homewood, Illinois, Richard D. Irwin, Inc., 1969. 10. J. Robert Lindsay and Arnold W. Sametz, Financial Management: An Analytical Approach, Homewood, Illinois, Richard D. Irwin, Inc., 1967. 11. Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment", American Economic Review (June 1959), pp. 261-97. 12. Franco Modigliani and Merton H. Miller, "Dividend Policy, Growth, and the Valuation of Shares", Journal of Business (October 1961), pp. 411-33. 13. Charles L. Prather and James E. Wert, Financing Business Firms, Homewood, Illinois, Richard D. Irwin, Inc., 1971. 14. James C. Van Home, Financial Management and Policy, Englewood Cliffs, New Jersey, Prentice-Hall, Inc., 1971, 2nd edition. 15. J. Fred Weston and Eugene F. Brigham, Managerial Finance, New York, Holt, Rinehart and Winston, Inc., 1972, 4th edition.

3. Joseph F. Bradley, Administrative Financial Management, New York, Holt, Rinehart and Winston, Inc., 1969, 2nd edition. 4. Thomas C. Committee, Managerial Finance for the Seventies, New York, McGraw-Hill Book Company, 1972. 5. Ward S. Curran, Principles of Financial Management, New York, McGraw-Hill Book Company, 1970. 6. Adolph E. Grunewald and Erwin Esser Nemmers, Basic Managerial Finance, New York, Holt, Rinehart and Winston, Inc., 1970. 7. Pearson Hunt, Charles M. Williams, and Gordon Donaldson, Basic Business Finance, Homewood, Illinois, Richard D. Irwin, Inc., 1966.

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