Investment ($000,000) (b) Smoothed investment opportunity schedule ect and the percentage cost of capital. Each box denotes a given project. Project A, for example, calls for an outlay of $3 million and promises a 17 percent rate of return; project B requires an outlay of $1 million and promises a 16 percent yield, and so on. The last investment, project E, simply involves buying 9 percent government bonds. By displaying this stepwise pattern of potential returns on a single graph, the firm's IOS is depicted. Figure 15.3(b) generalizes the IOS concept to show a smooth pattern of potential returns. The curve labeled IRR shows the internal rate of return potential for each project in the portfolio of investment projects available to the firm. It is important to remember that these projects are arrayed from left to right in terms of declining attractiveness as measured by the IRR criterion. Therefore, project A is more attractive than project E, and the IRR schedule is downward sloping from left to right.
Although the IOS provides important input into the capital budget decision-making process, by itself it is insufficient for determining the optimal capital budget. Both the returns and costs of potential projects must be considered. To define the optimal capital budget, a means for evaluating the marginal cost of funds must be incorporated into the process.
marginal cost of capital (MCC)
Financing cost of an additional investment project, expressed on a percentage basis
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