Reading 45: Cost of Capital-LOS d 习题精选 2011, investment, determine, schedule

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Session 11: Corporate Finance
Reading 45: Cost of Capital

LOS d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget.

 

 

The marginal cost of capital is:

A) tied solely to the specific source of financing.

B) equal to the firm's weighted cost of funds.

C) the cost of the last dollar raised by the firm.

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The “marginal” cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.

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Enamel Manufacturing (EM) is considering investing in a new vehicle. EM finances new projects using retained earnings and bank loans. This new vehicle is expected to have the same level of risk as the typical investment made by EM. Which one of the following should the firm use in making its decision?

A) Marginal cost of capital.

B) Cost of retained earnings.

C) After-tax cost of debt.

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The marginal cost of capital represents the cost of raising an additional dollar of capital. The cost of retained earnings would only be appropriate if the company avoided creditor-supplied financing or the issuance of new common or preferred stock (and preferred stock financing). The after-tax cost of debt is never sufficient, because a business, regardless of their size, always has a residual owner, and hence a cost of equity.