Average and marginal cost
- The marginal cost of capital is the cost of the incremental capital raised.
- Initially, as cheaper debt is added, average cost of capital will fall.
- After a minimum is reached, the average cost of capital will rise due to increased risk.
- The marginal cost will initially be lower than average: after the minimum, it will be higher.
Average and marginal cost
When to use WACC?
WACC can be used in investment appraisal in certain restricted circumstances:
- Business risk of investment project is similar to business risk of existing operations.
- Incremental finance is raised in proportions that preserve existing capital structure.
- Required return of existing finance sources is not affected by new investment project.
Practical problems with WACC
- Security market values may be unavailable:
- Use substitute security with similar risk, return, and maturity
- Add risk premium to yield on government bond
- Securities may be complex:
- Convertible securities
- Floating rate notes
- Foreign currencies
- Currency and interest rate swaps
Problems with calculating WACC
- Which sources of finance should be included in the WACC calculation?
- What about long-term bank debt?
- Use book value and average interest rate.
- Accounts may not provide adequate data.
- Internal information will be required.
- Company may have large range of securities.
- WACC is not constant.
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