Marginal cost of capital schedule is a graph that plots the cost of raising additional capital. MCC schedule plots the weighted average cost of each dollar of additional capital on the y-axis to the amount of new capital raised on the x-axis. As a company raises more funds, the costs of capital from different sources change.
The marginal cost of capital is upward sloping because when a greater amount of capital is raised, the cost of equity and debt financing increase. We calculate a break point using information on when the different sources’ costs change and the proportions that the company uses when it raises additional capital:
Let us understand this concept through an example.
A company’s target capital structure is 60 percent equity and 40 percent debt. The cost and availability of raising various amounts of debt and equity capital is shown below:
Amount of new debt
|Cost of debt
|Amount of new equity
|Cost of equity|
|≤ 4||14%||≤ 9.0||20%|
|> 4.0||16%||> 9.0||22%|
What is the WACC for raising the following amounts of capital: 5, 10, 15, and 20?
|Amount of capital||Debt (40%)||Equity (60%)||Cost of debt (in %)||Cost of equity (in %)||WACC
|5||0.4 * 5 = 2||0.6 * 5 = 3||0.4 * 14 = 5.6||0.6 * 20 = 12||17.6|
|10||0.4 * 10 = 4||0.6 * 10 = 6||0.4 * 14 = 5.6||0.6 * 20 = 12||17.6|
|15||0.4 * 15 = 6||0.6 * 15 = 9||0.4 * 16 = 6.4||0.6 * 20 = 12||18.4|
|20||0.4 * 20 = 8||0.6 * 20 = 12||0.4 * 16 = 6.4||0.6 * 22 = 13.2||19.6|
Floatation costs are the fees charged by investment bankers when a company raises external capital. There are two approaches to deal with floatation costs:
Approach 1: Incorporate flotation costs into the cost of capital. This will increase the cost of capital.
For example, consider a company that has a current dividend of $5 per share, a current price of $100 per share and an expected growth rate of 10%. The cost of equity without considering floatation costs would be:
If the floatation costs are 3% of the issuance, the cost of equity considering the floatation costs would be:
However, the problem with this approach is that floatation costs are not an ongoing expense, they are a cost that the firm incurs at the start of the project. Hence, we should not be discounting all future cash flows at a higher cost of capital. The correct way to treat floatation costs is to use approach 2.
Approach 2: We adjust the initial cash flow by the amount of floatation costs. We do not adjust the discount rate.
Let’s say in the above example, the company raised $100,000 for a project by issuing new shares. The floatation costs would be 3% of $100,000 i.e. $3,000. In this approach we increase the initial cash outlay of the project to $103,000. The cost of equity, however, remains unchanged at 15.5%.
In this reading, we saw several methods to estimate the cost of capital for a company or project. A survey of a large number of US company CFOs to understand the methods they use to estimate the cost of capital revealed the following: