Chapter 11, Problem 18PROB

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 of retained earnings is the maximum amount of fund that can be raised without issuing new common equity, since the equity portion of the new capital can be met through retained earnings.

$\text{Break-point}=\frac{\text{Retained earnings}}{\text{Weight of common equity}}$

There are two independent projects S and L. They have a cost of $150,000 and $140,000 respectively, with an IRR of 12% and 10%. The company’s capital structure consists of 20% debt and 80% common equity. After tax cost of debt, cost of retained earnings and cost of new common equity are 4%,10%,12.5% respectively. The company expects to generate $230,000 in retained earnings.