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### Subject 6. Marginal Cost of Capital Structure

The marginal cost of capital (MCC) is the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period.

The marginal cost of capital schedule is a graph that relates the firm's weighted average cost of each dollar of capital to the total amount of new capital raised.

The cost of capital is level to the point at which one of the costs of capital changes, such as when the company bumps up against a debt covenant, requiring it to use another form of capital. The break point (BP) is the dollar value of new capital that can be raised before an increase in the firm's weighted average cost of capital occurs.

Break point = Amount of capital at which the source's cost of capital changes / proportion of new capital raised from the source

Example

Consider the following schedule of the costs of debt and equity for a company.

Assuming the company's target capital structure is 50% debt and 50% equity, the corresponding marginal cost of capital schedule looks like this:

The break points are at \$10 million and \$20 million.

The company can invest up to \$10 million with the WACC = 9%. After \$10 million, the company will have to raise new equity and new debt at higher costs, and the WACC will rise to 12% if the company wants to raise an additional \$10 million.

The MCC is the cost of the last dollar raised by the company, while the WACC is the weighted average cost of all capital components used by the company. The MCC will increase as a firm raises more and more capital.

• Large, established firms typically obtain all their equity capital from retained earnings.
• Due to the floating costs of issuing new stocks, the cost of retained earnings is always less than the cost of newly issued common equity.
• If a firm requires so much capital that it has to issue new common stock, the WACC will rise because of the increased cost of new equity.

#### Practice Question 1

Gigantic Corporation has calculated the following:

WACCs = 5.75%
WACCe = 6.15%
REBP = \$35,750,000

Which of the following is the correct amount of new capital to be raised using MCC?

A. \$35,750,000 in new capital; MCC = 5.75%
B. \$35,750,000 in new capital; MCC = 6.15%
C. \$40,000,000 in new capital; MCC = 5.75%

Since \$35,750,000 in new capital exhausts retained earnings, the next dollar of capital will be raised at WACCe. As a result, the MCC at \$35,750,000 is WACCe = 6.15%.

#### Practice Question 2

The market value of XYZ Corp.'s common equity is currently \$600 million and the market value of their debt is \$400 million. The cost of equity is estimated at 12% and the before-tax cost of debt is estimated at 8%. Suppose that the company wishes to raise an additional \$150 million to finance its expansion. However, the company estimates the debt will now cost them 9% (before tax) and the equity will cost 14%. If the company wishes to maintain its existing capital structure, and its tax rate is 40%, what will be the company's new WACC?

A. 10.56%
B. 9.12%
C. 12.0%

Old WACC = 12%(.60) + (1-.4)(8%)(.40) = 9.12%
New WACC = 14%(.60) + (1-.4)(9%)(.40) = 10.56%

Notice how, by raising additional amounts of capital, the component cost of the entire capital amount increases (not just on the marginal capital).

#### Practice Question 3

ABC Company has estimated its REBP to be equal to \$75,000,000. Which of the following statements is true? (WACCs: the WACC before REBP; WACCe: the WACC after REBP)

A. If total new capital raised is less than \$75,000,000, then MCC = WACCs.
B. If total new capital raised is less than \$75,000,000, then MCC = WACCe.
C. If total new capital raised is greater than \$75,000,000, then MCC = WACCs.