Breakpoint on Marginal Cost Curve

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liaaba

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this was from Schweser,
Which one of the following statements about the marginal cost of capital (MCC) is TRUE?
A) The MCC is the cost of the last dollar obtained from bondholders.
B) The breakpoint on the marginal cost curve is calculated by dividing retained earnings by the equity weight in the capital structure.
C) The MCC is the cost of the last dollar obtained from shareholders.
D) The MCC falls as more and more capital is raised in a given period.
Your answer: B was correct!
The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings – bonds, preferred stock, and common stock – when the final dollar was obtained, regardless of its specific source.
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Breakpoint on the marginal cost curve was not discussed in the Cost of Capital (48) reading in Corp Fin, and it was specified in the LOS, but surprisingly, it showed up in this question from Schweser? Is this L1 material? or L2 or L3 perhaps? I.e. do we have to know this?
 
liaaba, this was definitely LI material in 2006, I’d be surprised if it isn’t in the 2007 curriculum too.
“LOS 46.c: Define target (optimal) capital structure, calculate a company’s weighted-average cost of capital, calculate a company’s marginal cost of capital and distinguish between the weighted-average cost of capital and marginal cost of capital.”
Schweser’s 2006 Book 4, p.11 sums it up nicely:
“The break point on the marginal cost curve is given by:
retained earnings break point = retained earnings / W_ce”
 
hiredguns1, this is the second time I’m going through the material, and for the marginal cost curve, the only coverage the text have on it is the interaction between it and the investment opportunity schedule (IOS), and that the intersection is the optimal capital budget….it didn’t mention anything about the breakpoint….
also, in the text (2007), for WACC and MAC, it basically said the 2 are the same and said they represent the cost to raise additional capital (i.e. both are strictly marginal cost), but the explanation given for LOS 48.d from Schweser has,
“The WACC is the weighted average cost of each capital component (debt, preferred stock, and common equity). MCC is the cost of the last dollar of new capital raised; therefore, the WACC increases as additional capital is raised. As the firm raises more capital, the MCC is likely to be higher than the WACC.”
Effectively identifying the 2 as different concepts…
Also, the only LOSs from reading 48 (cost of capital for 2007 CFAI text) concerning marginal cost curve are,
48.d Explain the analyst’s concern with the marginal cost of capital in evaluating investment projects, and explain the use of the marginal cost of capital and the investment opportunity schedule in determining the optimal capital budget for a company.
48.e Explain the marginal cost of capital’s role in determining the net present value of a project.
And does not include the LOS you mentioned above, which would seem like a perfect fit for the explanations I took from Schweser above…
This makes me worry a bit, even though the LOSs does not specify this concept, but the material from Schweser clearly does, I’m hoping it’s a mistake by Schweser…
Can anyone else with the 2007 CFAI text confirm my findings?
 
liaaba, based on the LOS you reprinted, it looks like a mistake by Schweser. The only verb is “explain” which doesn’t fit the question at all. Have you recently checked Schweser’s updates/errata?
http://schweser.com/news/news_updates.php?type=schweser
The first part of the 2007 CFAI text you cite is a bit concerning. WACC and the MCC are related, but certainly are not concepts or terms to be used interchangeably. The passage you cite from Schweser is consistant with my understanding of the two terms. Here are two quotes from Schweser’s notes last year: 2006 Book 4, p. 10:
“The marginal cost of capital (MCC) is the cos tof one more dollar of capital. The MCC increases as a firm increases the amount of capital it raises during a given period.”
“The WACC is the firm’s average cost of funds. It differs from the marginal cost of capital in that the MCC is the cost of the last dollar raised by the company. As the firm raises more and more capital, the MCC is likely to be higher than the WACC.”
Like you, I’m curious to see what other current LI candidates have to say.
 
Agree with Liaaba that CFAI treats WACC and MCC the same way, as well as there is not anything related to breakpoint on the marginal cost curve
CFAI puts an emphasis on MCC, as the concern is the cost of the additional capital for a potential investment project (and it uses WACC as a proxy for MCC)
 
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