2. Marginal cost of capital
Definition
The WACC applicable to the next dollar of the total new financing.
Capital is any money used to finance a business and/or its
operations.
Capital can be acquired from many different sources: traditional
debt or equity financing or owner financing, grants, gains on
investment capital, retained earnings, accrual financing contracts
and forward payment agreements on capital.
The WMCC and cost of capital change over time.
3. Example:
Once retained earnings are depleted, Newco decides
to access the capital markets to raise new equity.
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, assume the company has
a flotation cost of 5%. Newco's cost of new equity
(kc) is thus 12.3%, as calculated below:
kc = 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)
Marginal Cost of Capital
4. Answer:
Using this new cost of equity, we can determine
the WACC as follows:
WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) +
(0.55)(0.123)
WACC = 0.086, or 8.6%
The WACC has been stepped up from 8.4% to
8.6% given Newco's need to raise new equity.
Marginal Cost of Capital
5. Look Out!
At some point, as the company continues to raise capital,
the MCC can be higher than the WACC.
Marginal Cost of Capital
6. 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:
7. 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%?
MCC Vs. WACC
8. 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.
MCC Vs. WACC
