Marginal Cost of Capital

CFA Level I Corporate Finance
#1

Hello All,

Optimal Capital budget is the intersection of Marginal Cost of Capital and Investment Opportunity schedule. Why does the graph of the Investment opportunity schedule decrease with respect to Amount of new capital, and why does Marginal cost of capital increase with respect to Amount of new capital? The curriculum doesn’t explain why this happens. I have made a figure about this. (http://s14.postimg.org/raa471c81/Untitled.png)

Any thoughts would be appreciated.

Thanks

#2

After thinking about this for sometime, I believe MCC could be thought of as Marginal cost in Economics. I am good with it’s going up. However, why would the opportunity schedule go down? Is it similar to average product curve? Just curious.

Thanks

#3

I wrote an article on the marginal cost of capital (and on calculating break points) that may be helpful (http://financialexamhelp123.com/marginal-cost-of-capital-break-points/), although you said that you’d already made peace with that part of your original question.

As for the opportunity schedule: it’s pretty simple. You list all of the projects you can do:

  • Project A: $20 million initial investment, IRR = 8%
  • Project B: $18 million, IRR = 11%
  • Project C: $40 million, IRR = 9.5%
  • Project D: $25 million, IRR = 3%

and so on.

You’d prefer to do projects with higher IRRs to projects with lower IRRs, so you rank them by IRR:

  • Project B: $18 million, IRR = 11%
  • Project C: $40 million, IRR = 9.5%
  • Project A: $20 million, IRR = 8%
  • Project D: $25 million, IRR = 3%

That’s your opportunity schedule:

  • $0 – $18 million @ 11%
  • $18 million – $58 million @ 9.5%
  • $58 million – $78 million @ 8%
  • $78 million – $103 million @ 3%

and so on.

#4

Thank you S2000magician. Your article and this post makes perfect sense now.

Utmost regards,

Allalongthewatchtower

#5

Good to hear.

Thanks.