As the volume of financing increases the costs of the

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Unformatted text preview: ng on the volume of financing that the firm plans to raise. As the volume of financing increases, the costs of the various types of financing will increase, raising the firm’s weighted CHAPTER 11 weighted marginal cost of capital (WMCC) The firm’s weighted average cost of capital (WACC) associated with its next dollar of total new financing. The Cost of Capital 485 average cost of capital. Therefore, it is useful to calculate the weighted marginal cost of capital (WMCC), which is simply the firm’s weighted average cost of capital (WACC) associated with its next dollar of total new financing. This marginal cost is relevant to current decisions. The costs of the financing components (debt, preferred stock, and common stock) rise as larger amounts are raised. Suppliers of funds require greater returns in the form of interest, dividends, or growth as compensation for the increased risk introduced by larger volumes of new financing. The WMCC is therefore an increasing function of the level of total new financing. Another factor that causes the weighted average cost of capital to increase is the use of common stock equity financing. New financing provided by common stock equity will be taken from available retained earnings until this supply is exhausted and then will be obtained through new common stock financing. Because retained earnings are a less expensive form of common stock equity financing than the sale of new common stock, the weighted average cost of capital will rise with the addition of new common stock. Finding Break Points break point The level of total new financing at which the cost of one of the financing components rises, thereby causing an upward shift in the weighted marginal cost of capital (WMCC). To calculate the WMCC, we must calculate break points, which reflect the level of total new financing at which the cost of one of the financing components rises. The following general equation can be used to find break points: BPj AFj wj (11.10) where BPj AFj wj EXAMPLE break point for financing source j amount of funds available from financing source j at a given cost capital structure weight (stated in decimal form) for financing source j When Duchess Corporation exhausts its $300,000 of available retained earnings (at kr 13.0%), it must use the more expensive new common stock financing (at kn 14.0%) to meet its common stock equity needs. In addition, the firm expects that it can borrow only $400,000 of debt at the 5.6% cost; additional debt will have an after-tax cost (ki) of 8.4%. Two break points therefore exist: (1) when the $300,000 of retained earnings costing 13.0% is exhausted, and (2) when the $400,000 of long-term debt costing 5.6% is exhausted. The break points can be found by substituting these values and the corresponding capital structure weights given earlier into Equation 11.10. We get the dollar amounts of total new financing at which the costs of the given financing sources rise: BPcommon equity $300,000 0.50 $600,000 BPlong-term debt $400,000 0.40 $1,000,000 486 PART 4 Long-Term Financial Decisions Calculating the WMCC weighted marginal cost of capital (WMCC) schedule Graph that relates the firm’s weighted average cost of capital to the level of total new financing. EXAMPLE Once the break points have been determined, the next step is to calculate the weighted average cost of capital over the range of total new financing between break points. First, we find the WACC for a level of total new financing between zero and the first break point. Next, we find the WACC for a level of total new financing between the first and second break points, and so on. By definition, for each of the ranges of total new financing between break points, certain component capital costs (such as debt or common equity) will increase. This will cause the weighted average cost of capital to increase to a higher level than that over the preceding range. Together, these data can be used to prepare a weighted marginal cost of capital (WMCC) schedule. This is a graph that relates the firm’s weighted average cost of capital to the level of total new financing. Table 11.2 summarizes the calculation of the WACC for Duchess Corporation over the three ranges of total new financing created by the two break points— $600,000 and $1,000,000. Comparing the costs in column 3 of the table for each of the three ranges, we can see that the costs in the first range ($0 to $600,000) are those calculated in earlier examples and used in Table 11.1. The second range ($600,000 to $1,000,000) reflects the increase in the common stock equity cost to 14.0%. In the final range, the increase in the long-term debt cost to 8.4% is introduced. The weighted average costs of capital (WACC) for the three ranges are summarized in the table shown at the bottom of Figure 11.1. These data describe the TABLE 11.2 Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess Corporation Range of total new financing $0 to $600,000 Sou...
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