Marginal Cost of Capital

The marginal cost of capital (MCC) is the extra financing cost necessary to fund an additional investment project, expressed on a percentage basis. When the firm is considering an entire portfolio of potential investment projects, the marginal cost of capital is the incremental financing cost of a relevant mix of debt and equity financing. Therefore, the MCC is typically given by the firm's weighted-average cost of capital. As drawn in Figure 15.3(b), the marginal cost of capital is constant at 10 percent up until the point where the firm has raised an additional $8 million. After this point, capital costs begin to rise. Given these IOS and MCC schedules, the firm should accept projects A through D, obtaining and investing $11 million. Project E, the government bond investment alternative, should be rejected. The smooth curves in Figure 15.3(b) indicate that the firm should invest B* dollars, the optimal capital budget. At this investment level, the marginal cost of capital is 12 percent, exactly the same as the IRR on the marginal investment project.

Whenever the optimal capital budget B* is determined, the IRR always equals the MCC for the last project undertaken. The condition that must be met for any budget to be optimal is that IRR = MCC. This means that the final project accepted for investment is a breakeven project, in that it provides an IRR that is just equal to the discount rate. For this project, NPV = 0, PI = 1, and IRR = k. By accepting all earlier and more attractive projects, value maximization is assured because the firm has accepted all projects where NPV > 0, PI > 1, and IRR > k. This means that the area above the MCC schedule but below the IRR (or IOS schedule) represents the net profit earned on the firm's new investment projects. The IRR = MCC optimal capital budget condition is completely analogous to the MR = MC requirement for profit maximization. When MR = MC, all profitable units have been produced and sold. When IRR = MCC, all profitable investment projects have likewise been accepted.

economic value added (EVA©)

Adjusted accounting profit minus the cost of capital employed

Economic Value-Added Analysis

An intuitive and increasingly popular method for judging the efficiency of the firm's capital budgeting process is called economic value-added (EVA©) analysis. EVA© is an accounting-based estimate of the profit added through the firm's capital budgeting process. The formula for EVA© is

Economic Value Added (EVA®)

= Adjusted Earnings - Capital Costs

= Adjusted Earnings - (Marginal Cost of Capital X Value of Capital Employed)

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