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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