General Studies · Marginal Cost of Capital
A company uses a Weighted Marginal Cost of Capital (WMCC) approach for determining the optimal capital budget. The company observes that for large capital expenditures, the cost of both debt and equity increases significantly. What concept does this observation relate to, and how does it affect the optimal budget decision?
- 1Concept: Capital Receipts. Effect: The increasing cost reduces the total numerical value of the capital raised.
- 2Concept: The Break Point in the Marginal Cost of Capital (MCC) schedule. Effect: The increasing cost shifts the MCC curve upwards, potentially causing the firm to reject projects that would otherwise be accepted under a lower WACC.✓
- 3Concept: Risk-free Rate. Effect: The increasing cost makes the optimal budget decision easier by only selecting projects with IRR over 20%.
- 4Concept: Flotation Cost and the Cost of Capital. Effect: The increasing cost must be ignored as it is a temporary market anomaly.
Correct answer
Concept: The Break Point in the Marginal Cost of Capital (MCC) schedule. Effect: The increasing cost shifts the MCC curve upwards, potentially causing the firm to reject projects that would otherwise be accepted under a lower WACC.
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