Supriya Ghosh (Editor)

Marginal cost of capital schedule

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Marginal cost of capital (MCC) schedule is a graph that relates the firm's weighted average cost of each unit of capital to the total amount of new capital raised.

Contents

The WACC is the minimum rate of return allowable, and still meeting financial obligations such as debt, interest payments, dividends etc... Therefore, the WACC averages the required returns from all long-term financing sources (debt and equity).

the WACC is based on cash flows, which are after-tax. By the same notion, the WACC should be calculated on an after-tax basis.

Debt

Advantages:

  • usually cheaper than equity
  • no loss of control (voting rights)
  • upper limit is placed on share of profits
  • flotation costs are typically lower than equity
  • interest expense is tax deductible

    • Disadvantages:

  • legally obliged to make payments no matter how tight the funds on hand are
  • in the case of bonds, full face value comes due at one time
  • taking on more debt = taking on more financial risk (more systematic risk) requiring higher cash flows


    • The firm's debt component is stated as kd and since there is a tax benefit from interest payments then the after tax WACC component is kd(1-T); where T is the tax rate.

    Equity

    Advantages:

  • no legal obligation to pay (depends on class of shares)
  • no maturity
  • lower financial risk
  • it could be cheaper than debt, with good prospects of profitability

    • Disadvantages:

  • new equity dilutes current ownership share of profits and voting rights (control)
  • cost of underwriting equity is much higher than debt
  • too much equity = target for a leveraged buy-out by another firm
  • no tax shield, dividends are not tax deductible, and may exhibit double-taxation

    • 3 ways of calculating KKe:

    1. Capital Asset Pricing Model
    2. Dividend Discount Method
    3. Bond Yield Plus Risk Premium Approach

    Cost of new equity should be the adjusted cost for any underwriting fees terme flotation costs (F)

    Ke = D1/P0(1-F) + g; where F = flotation costs, D1 is dividends, P0 is price of the stock, and g is the growth rate.

    Weighted average cost of capital equation:

    WACC= (Wd)[(Kd)(1-t)]+ (Wpf)(Kpf)+ (Wce)(Kce)

    More to come: (K preferred shares, EVA, MCC, MCC schedule and demonstration, IOS schedule and demonstration, MCC/IOS schedules)

    References

    Marginal cost of capital schedule Wikipedia
    (Text) CC BY-SA