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Hello,
Could you please help to answer couple of questions:
At page 26 open tuition notes F3 there are 3rd and 4th bullet point at that page it says – whilst gearing up, company should appraise projects at the cost of the extra finance raised (the marginal cost of capital) – could you explain what do they mean by this marginal cost of capital and how this works?
could you explain the 4th bullet point which says – once optimal gearing has been achieve the projects shold be appraised at the cost of extra finance raised (?? what are these costs?). However since the wacc remain same, the cost of the extra finance will be equial to the wacc(could you explain what this mean, I am confused how to explain it, could you help please?)
Thank you in advance for your help!!
Suppose that at the moment the overall cost of capital (the WACC) is 15%. Suppose you borrow a bit more and the cost of that extra bit is (say) 10%. Obviously it would be sensible to borrow the extra (because it costs less), and the overall cost (the WACC) would fall a little bit – maybe the WACC falls to (say) 14%. (I am obviously inventing figures here to illustrate).
In the above, the 10% cost of the extra bit is the marginal cost. You can’t be asked to do any calculations of this in the exam but you can be expected to be aware of the idea.Provided you can borrow more at a lower cost that the current WACC then is is worth borrowing more (and the WACC will reduce). However once the extra cost is more than the WACC it is not worth borrowing more because the WACC will increase.
The optimum occurs when the WACC is at a minimum, and if they then raise future finance in such a way as to keep the gearing the same, then the WACC will stay at the minimum and the extra cost of more finance will be equal to the WACC.
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