9.3 Marginal Cost of Capital

Marginal Cost of Capital

Definition and Relevance

The marginal cost of capital (MCC) is the weighted average cost of the last dollar of new capital a company raises. It reflects the blended cost across all funding sources (debt, preferred stock, common equity) at a given level of total new financing.

Why does this matter? MCC serves as the hurdle rate in capital budgeting. When you evaluate a project using net present value (NPV) or internal rate of return (IRR), the MCC is the discount rate you compare against. The decision rule is straightforward: invest in every project whose expected return exceeds the MCC, because those projects have a positive NPV and increase shareholder value. Reject anything that falls below it.

Factors Affecting MCC

The MCC depends on the cost and proportion of each funding source in the capital mix. Several dynamics push MCC higher as a firm raises more capital:

• Cost of debt is typically the cheapest source because interest payments are tax-deductible and debt holders face lower risk than equity holders. But as a firm takes on more debt, lenders demand higher interest rates to compensate for rising default risk and the growing chance of financial distress.
• Cost of preferred stock falls between debt and common equity. It carries a fixed dividend obligation but lacks the tax shield that debt provides.
• Cost of common equity is the most expensive source because shareholders are residual claimants, meaning they get paid last. As a firm issues more equity, costs can rise further due to ownership dilution and negative signaling effects (investors may interpret new equity issuance as a sign that management thinks the stock is overvalued).

The net result: as a company exhausts its cheapest financing and taps progressively more expensive sources, the MCC rises. This creates an upward-sloping MCC schedule.

Constructing the MCC Schedule

Components of the MCC Schedule

The MCC schedule is a graph (or table) showing how the weighted average cost of capital changes at different levels of total new financing. It has a characteristic stair-step shape because the cost jumps each time the firm exhausts a cheaper source and must shift to a more expensive one.

The point where a cheaper source runs out and the WACC jumps is called a break point. You calculate it as:

$\text{Break Point} = \frac{\text{Maximum amount of a given source}}{\text{That source's weight in the target capital structure}}$

To build the schedule, follow these steps:

1. Identify each financing source, its after-tax cost, and the maximum amount available at that cost.
2. Determine the firm's target capital structure weights (the proportion of debt, preferred stock, and equity).
3. Calculate the break points where cheaper sources are exhausted.
4. Compute the WACC for each range between break points, using the appropriate cost for each source in that range.
5. Plot the WACC against total new capital raised. Each break point marks a step up in cost.

Example of MCC Schedule Construction

Suppose a firm has these financing options and uses them in proportion as it raises capital:

For simplicity, assume the firm draws on the cheapest source first:

• First $\$10$ million: Funded entirely with debt at 6%, so MCC = 6%.
• Next $\$5$ million ($\$10$–$\$15$ million total): Debt is exhausted, so the firm uses preferred stock at 8%. The blended MCC across this range is a weighted average of the debt already raised and the new preferred stock, pushing the marginal rate above 6%.
• Beyond $\$15$ million: Both debt and preferred stock are exhausted. Additional capital comes from common equity at 12%, pulling the MCC higher still.

Note: In practice, most firms raise capital in their target proportions (e.g., 40% debt, 10% preferred, 50% equity) rather than sequentially exhausting one source at a time. The break-point formula above accounts for this. The simplified sequential example here just illustrates why the schedule steps upward.

Optimal Capital Budgeting

Determining the Optimal Capital Budget

To find the right amount to invest, you compare two schedules on the same graph:

• The MCC schedule (upward-sloping), showing the cost of each additional dollar of financing.
• The Investment Opportunity Schedule (IOS) (downward-sloping), which ranks all available projects from highest to lowest expected return.

The optimal capital budget is the dollar amount where the IOS and MCC curves intersect. At that point, the return on the marginal project exactly equals its financing cost. Every project to the left of the intersection earns more than it costs (positive NPV), so you accept it. Every project to the right costs more than it returns (negative NPV), so you reject it.

Special Cases and Shifts

• If the IOS lies entirely above the MCC schedule, every available project creates value, and the firm should accept them all.
• If the IOS lies entirely below the MCC schedule, no project covers its financing cost, and the firm should reject them all.

Changes in either schedule shift the optimal budget:

• MCC shifts up (e.g., rising interest rates or a credit downgrade): Fewer projects clear the higher hurdle, so the optimal budget shrinks.
• IOS shifts up (e.g., new market opportunities or technological breakthroughs): More projects exceed the MCC, so the optimal budget grows.

Firms should revisit both schedules regularly. Interest rates change, credit conditions evolve, and new investment opportunities appear. Keeping the MCC and IOS current ensures capital budgeting decisions stay aligned with shareholder value.