The cost of the different sources of capital tends to change as a company raises additional capital, thereby resulting in a change in the company’s weighted average cost of capital (WACC). The marginal cost of capital (MCC) schedule depicts this relationship by reflecting WACC for various amounts of capital raised.
The MCC schedule is not a smooth graph but tends to slope upwards in a step-up fashion. This is because the MCC tends to increase as additional capital is raised. Two reasons why a company’s marginal cost of capital tends to increase as more capital is raised are: (i) Bond covenants or debt incurrence tests may place restrictions on the company’s ability to incur additional debt, and (ii) the company may experience deviations from its target capital structure.
The amount of capital at which the weighted average cost of capital changes is known as the break point. This occurs whenever the cost of one of the sources of capital changes.
The formula for determining a break point is –
A company raises capital according to its target capital structure of 50% debt and 50% equity. Its cost of debt capital remains unchanged when it seeks to raise anywhere up to an additional $6 billion in debt capital, however, once it attempts to raise more than this amount of debt capital, its cost of capital increases. Using this information alone, identify one of the company’s break point.
Breakpoint = $6 million/0.50 = $12 million.
Which of the following statements is most accurate?
A. The MCC Schedule depicts the relationship between the amount of new capital being raised and the cost of equity capital only.
B. The MCC Schedule depicts the relationship between the amount of new capital being raised and the weighted average cost of capital.
C. The MCC Schedule is usually downward sloping.
The correct answer is B.
A is incorrect because the MCC schedule depicts the relationship between amount of new capital and the WACC and not just the cost of one source of capital i.e. equity. C is incorrect because the MCC Schedule is upward sloping.
Reading 36 LOS 36k:
Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points