average cost of capital.Therefore, it is useful to calculate theweighted marginal
cost of capital (WMCC),which is simply the firm’s weighted average cost of cap-
ital (WACC) associated with itsnext dollarof 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 ofnewfinancing. 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 capi-
tal will rise with the addition of new common stock.
Finding Break Points
To calculate the WMCC, we must calculate break points,which reflect the level
of totalnew financing at which the cost of one of the financing components rises.
The following general equation can be used to find break points:
BPj (11.10)
where
BPjbreak point for financing source j
AFjamount of funds available from financing source jat a given cost
wjcapital structure weight (stated in decimal form) for financing source j
EXAMPLE When Duchess Corporation exhausts its $300,000 of available retained earnings
(at kr13.0%), it must use the more expensive new common stock financing (at
kn14.0%) 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 corre-
sponding capital structure weights given earlier into Equation 11.10. We get the
dollar amounts of totalnew financing at which the costs of the given financing
sources rise:
BPcommon equity$600,000
BPlong-term debt$1,000,000
$400,000
0.40
$300,000
0.50
AFj
wj
CHAPTER 11 The Cost of Capital 485
break point
The level of totalnew 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).
weighted marginal cost
of capital (WMCC)
The firm’s weighted average cost
of capital (WACC) associated
with its next dollarof total new
financing.