WEIGHTED MARGINAL COST OF
CAPITAL (WMCC)
1
As the total financing increases, WACC will also
increase.
Which WACC should the firm use to evaluate
investment opportunities?
In making decision, financial managers have to
take into consideration the marginal cost of
capital.
WMCC represents the appropriate criterion for
making investment decisions.
WEIGHTED MARGINAL COST OF
CAPITAL (WMCC)
2
WMCC is a graph that relates the firms
weighted average cost of each dollar of
capital to the total amount of new capital
raised.
In making decision, the firm should invest as
long as the internal rate of return (IRR) is
greater or at least equal to marginal cost of
capital.
Example:
Below is the marginal cost of capital ABC Co.
1
6
1
4
1
2
1
0
g
n
i
k
ea int
r
B o
p
WMCC Curve
8
6
4
2
1
Financing ($ millions)
Example (cont)
Investment opportunity for ABC Co.
1
6
1
4
1
2
1
0
Investment
Estimated
Cost
IRR
$1,450,0
00
12
%
C
A
8%
$800,00
0
C
Rearrange$1,750,0
based on the
14
biggest IRR to the
00 smallest IRR
%
4
2
1750k
1
1450k 800
k
2
Financing ($ millions)
Example (cont)
Combine the WMCC curve & the investment
1
chart
6
1
4
1
2
1
0
8
6
4
2
IRR= 14%
IRR= 12%
WMCC Curve
ACCEPT if
IRR= 8%
1750k
1
IRR > cost of capital
1450k 800
k
2
Financing ($ millions)
STEPS IN MAKING DECISION
6
1. Determine the weight of each source of
capital structure.
2. Finding breaking points
Finding the break points in the WMCC
schedule will allow us to determine at what
level of new financing the WACC will increase
due to the factors listed above.
3. Calculate the cost s of each individual
source of capital.
Cont
7
4. Compute the new WACC, which will be
different as the amount of financing
increases.
5. Construct graph that compares internal
rate of return with WACC.
You have to rearranged the investment in
descending order based on their IRR.
6. Make decision
Accept investment with IRR > WMCC
EXAMPLE 1 :
8
JM is considering three investment.
Investment
Investment
Cost
IRR (%)
RM200,000
17%
RM 320,000
18%
RM 180,000
16%
The desired financing mix is as follow.
Total Liabilities and
Capital Structure
Equity
Mix
Bonds
35%
Common equity
65%
Cont
9
The company wishes to maintain the capital
structure for any additional financing.
The after-tax cost of bond is 10% and cost of
internal equity is 16%.
The company capital structure consist of
RM175,000 debt & RM325,000 internal equity.
A new issues of common stock will cost 20% and
additional debt financing will cost 12%
Questions:
1. Construct a weighted marginal cost of capital.
2. Which project should be accepted?
Answers
Answers..
1
0
Step 1
Step 2
Step 3
- Determine the weight of each source of capital structure.
- Finding breaking points
- Determine the cost s of each individual source of capital.
Breaking
Point
Range of
total
financing
Source
Proporti
on
Amount of
capital
Cost of
Capital
Bond
35%
175 000
500 000
0 500 000
10%
Equity
65%
325 000
500 000
0 500 000
16%
Step 4
- Compute the new WACC, which will be different as the amount of
financing increases.
Range of
total
financing
0 -500 000
Source
Proportion
Cost of
Capital
Bond
0.35
10%
3.50%
Equity
0.65
16%
10.4%
1.00
> 500 000
WACC
13.90%
Bond
0.35
12%
4.20%
Equity
0.65
20%
13.00%
17.20%
Step 5
Step 6
- Construct graph that compares internal rate of return with WACC.
- Make decision.
Financing ($)
EXAMPLE 2 :
Exercise:
1
3
Gagah Corporation is contemplating 3 major
capital investments in 2008. The financing will
consist of 50% debt and 50% common. Based
upon the anticipated profits during 2008,the
company should have RM1,500,000 in profits
available for einvestment(internal funds) and
the cost is 15%. The cost of debt is 12% for
the first RM1,000,000, thereafter the cost will
be 15%. If additional common financing is
needed it will cost 17%.
Cont
1
4
Cost of Investment
Expected IRR
Geological
RM1,500,000
14%
Water
RM2,000,000
18%
Drilling RM1,000,000
11%
Calculate:
1. Construct the weighted marginal cost of capital
curve
2. Which project should be accepted?
Answers
Answers..
1
5
