Introductory Corporate Finance: Cost of Capital - Marginal Cost of Capital, MCC Schedule and Breakpoints

What This Is

The Marginal Cost of Capital (MCC) schedule and breakpoints are essential tools in corporate finance for evaluating capital structure decisions. The MCC schedule shows the incremental cost of capital for each additional dollar invested in a specific asset or project, while breakpoints represent the points at which the cost of capital changes. For example, consider a company like Apple, which has a market capitalization of $2 trillion and a debt-to-equity ratio of 0.2. If Apple issues new debt to finance a project, the MCC schedule will help determine the optimal level of debt and the corresponding cost of capital.

Key Formulas & Models

• MCC = (?D / ?V) × (rD - rE) – marginal cost of capital; measures the incremental cost of capital for each additional dollar invested.
  • ?D: change in debt
  • ?V: change in firm value
  • rD: cost of debt
  • rE: cost of equity
• WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
• Cost of Equity = Rf +-× (Rm - Rf) – cost of equity; measures the expected return on equity.
  • Rf: risk-free rate
  • ?: beta coefficient
  • Rm: market return
• Cost of Debt = (1 - T) × rd – cost of debt; measures the after-tax cost of debt.
  • T: tax rate
  • rd: cost of debt
• Breakpoint = (?D / ?V) × (rD - rE) – breakpoint; represents the point at which the cost of capital changes.
• ?WACC = (?D / ?V) × (rD - rE) × (wd / V) – change in WACC; measures the impact of a change in debt on the weighted average cost of capital.
• ?WACC = (?D / ?V) × (rD - rE) × (we / V) – change in WACC; measures the impact of a change in equity on the weighted average cost of capital.

Step-by-Step Calculation

1. Determine the cost of debt and equity using the formulas above.
2. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1-T) + wps × rps + we × re.
3. Determine the marginal cost of capital (MCC) using the formula MCC = (?D / ?V) × (rD - rE).
4. Identify the breakpoints by solving for the points at which the cost of capital changes.
5. Calculate the change in WACC using the formula ?WACC = (?D / ?V) × (rD - rE) × (wd / V) or ?WACC = (?D / ?V) × (rD - rE) × (we / V).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value to reflect the current market price of the firm's securities.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs to reflect the actual cost of issuing new securities.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs represent the benefits that could have been obtained from alternative uses of resources.

Exam / CFA Tips

• Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Understand the difference between IRR and NPV ranking.
• Recognize the dividend irrelevance theorem and its implications for capital structure decisions.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, and a tax rate of 25%. Compute the degree of financial leverage (DFL) using the formula DFL = EBIT / (EBIT - Interest).

Answer: DFL = 10 / (10 - 2) = 2.5

Explanation: The DFL measures the sensitivity of EBIT to changes in sales.

Last-Minute Cram Sheet

• MCC: marginal cost of capital; measures the incremental cost of capital for each additional dollar invested.
• WACC: weighted average cost of capital; used as discount rate.
• Cost of Equity: Rf +-× (Rm - Rf); measures the expected return on equity.
• Cost of Debt: (1 - T) × rd; measures the after-tax cost of debt.
• Breakpoint: (?D / ?V) × (rD - rE); represents the point at which the cost of capital changes.
• ?WACC: (?D / ?V) × (rD - rE) × (wd / V); measures the impact of a change in debt on the weighted average cost of capital.
• ?WACC: (?D / ?V) × (rD - rE) × (we / V); measures the impact of a change in equity on the weighted average cost of capital.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• The dividend irrelevance theorem states that the value of the firm is independent of its dividend policy.
• The weighted average cost of capital (WACC) is a weighted average of the costs of debt and equity.