Marginal Cost of Capital (MCC) for CA Intermediate

Understand Marginal Cost of Capital

Key rules to remember

Marginal cost of capital

MCC = Σ (wᵢ × kᵢ)

wᵢ is the target proportion of source i in the new capital. kᵢ is the current after-tax cost of raising that source. Weights must add up to 100%.

Break point

Break point = Amount of a source available at a given cost ÷ Weight of that source in the capital structure

It is the total new capital at which that source's cost changes. Compute it for every cost change, then sort the break points in order.

After-tax cost of debt (irredeemable)

kd = Interest rate × (1 − t)

Use the new borrowing rate, not the old coupon. t is the tax rate. For redeemable debt or flotation costs, use the method from the Cost of Debt topic.

Cost of equity (dividend growth model)

ke = D₁ ÷ P₀ + g

D₁ is the expected dividend next year. P₀ is the current market price (net of flotation cost for new issue). g is the constant growth rate.

Decision rule

Accept a project if IRR > MCC at that level of funds

Where a project spans two MCC ranges, compare its IRR with the MCC of the range that its funds fall in. Use the higher MCC to be safe.

How to solve Marginal Cost of Capital questions

1. 1Write down the target capital structure for new funds (the weights). If the question gives no target, use the proportions of the planned new raising.
2. 2List the after-tax cost of each source at each level. Convert debt cost to after-tax using (1 − t). Calculate equity cost with the model given.
3. 3Find where each cost changes. For every change, compute the break point = amount available at that cost ÷ weight of that source.
4. 4Sort all break points in ascending order. These split total new capital into ranges.
5. 5For each range, pick the applicable cost of every source and compute MCC = Σ weight × cost. Show this as a small table.
6. 6If projects are given, rank them by IRR (highest first) and add their outlays cumulatively.
7. 7Compare each project's IRR with the MCC of the range its funds fall in. Accept if IRR is higher; reject otherwise.
8. 8State the final conclusion: which projects are accepted, the total capital raised and the MCC at that level.

Quickest way: Fast MCC schedule in four lines

Common mistakes in Marginal Cost of Capital

• Using the existing capital structure weights instead of the target weights for new funds.

  Students treat MCC like WACC and copy the balance sheet proportions.

  Fix: Read the question for the proportion in which new funds are raised. Use the book-value weights only if the question explicitly says to.

• Using the pre-tax cost of debt.

  The rate is given as a plain percentage and the tax step is forgotten.

  Fix: Always write kd = rate × (1 − t) as your first line for debt. Interest is tax-deductible, so the effective cost is lower.

• Calculating the break point as the amount of cheap source, without dividing by its weight.

  Students think the cheap source runs out at the same total as its own amount.

  Fix: The cheap source is only a fraction of total capital. Divide its available amount by its weight to get the total capital at which the cost changes.

• Missing a range because two break points were not sorted.

  Students compute break points for debt and equity and jump straight to MCC.

  Fix: List all break points in ascending order first. The number of ranges is the number of break points plus one.

• Comparing project IRR with the old WACC.

  WACC is the more familiar cut-off rate.

  Fix: For new funds, compare IRR with the MCC of the relevant range. The old WACC reflects past capital, not the price of the next rupee.

• Using the historical coupon or past dividend as the cost of new capital.

  Book data is easy to see in the question.

  Fix: Use current market-based costs, such as the current borrowing rate and the current price in the dividend model, for the new funds.

Worked examples