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LOS k: Describe the marginal cost of capital schedule, explain why it may be upwardsloping with respect to additional capital, and calculate and interpret its breakpoints.

Which of the following is used to illustrate a firm’s weighted average cost of capital (WACC) at different levels of capital?

A)
Schedule of marginal capital break points.

B)
Marginal cost of capital schedule.

C)
Cost of capital component schedule.

The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is usually upward sloping and is a function of a firm’s capital structure and its cost of capital at different levels of total capital investment.

The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will:

A break point refers to a level of new investment at which a component’s cost of capital changes. The formula for break point is:

As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component’s cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle’s debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.

Simcox Financial is considering raising additional capital to finance a takeover of one of the firm’s major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:

Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively?

$428.6 million

$533.3 million

$428.6 million

$615.4 million

$375.0 million

$615.4 million

A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.

Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Stolzenbach Technologies has breakpoints for raising additional financing at both:

A)	$500 million and $1,000 million.

B)	$500 million and $700 million.

C)	$400 million and $700 million.

Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints.

Break point_{Debt > $200mm} = ($200 million ÷ 0.4) = $500 million

Break point_{Debt > $500mm} = ($400 million ÷ 0.4) = $1,000 million

Break point_{Equity > $300mm} = ($300 million ÷ 0.6) = $500 million

Break point_{Equity > $700mm} = ($700 million ÷ 0.6) = $1,167 million

A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate?

A)	A project’s internal rate of return decreases when a breakpoint is reached.

B)	An increase in the after-tax cost of debt may occur at a break point.

C)	Any given project’s NPV will decline when a breakpoint is reached.

The internal rate of return is independent of the firm’s cost of capital. It is a function of the amount and timing of a project’s cash flows.

Which one of the following statements about the marginal cost of capital (MCC) is most accurate?

A)	The MCC is the cost of the last dollar obtained from bondholders.

B)	A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.

C)	The MCC falls as more and more capital is raised in a given period.

A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure.

The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings – bonds, preferred stock, and common stock – when the final dollar was obtained, regardless of its specific source.

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $149	4.2%	$0 to $399	7.5%
$150 to $349	5.0%	$400 to $799	8.5%

Amount of New Debt (in millions)	After-tax Cost of Debt	Amount of New Equity (in millions)	Cost of Equity
$0 to $199	4.5%	$0 to $299	7.5%
$200 to $399	5.0%	$300 to $699	8.5%
$400 to $599	5.5%	$700 to $999	9.5%