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Break point is the total amount of new investments that can be financed and the new capital that can be raised before a jump in marginal cost of capital is expected. It is the point at which the marginal cost of capital curve breaks out from its flat trend.
The break point can be worked out by dividing the retained earnings for the period by the weight of the retained earnings in the target capital structure. The retained earnings in a period equals the product of net income for the period and the retention rate (also called plow-back rate), which equals 1 minus the dividend payout ratio.
The following equation can be used to calculate the break point:
|Break Point =||NI × (1 — DPR)|
Where NI is the net income for the period, DPR is the dividend payout ratio, i.e. the dividends declared dividend by net income and We is the weight of retained earnings in the target capital structure.
The break points are helpful in creating the marginal cost of capital curve, a graph that plots capital raised on the X-axis and marginal weighted average cost of capital on the Y-axis.
Your company’s marginal cost of capital was 10% at the start of 2017. Its net income for the year was $30 million, 30% of which was paid out in dividends. Retained earnings form 45% of the target capital structure of the company.
The company’s break point equals retained earnings for the period divided by proportion of retained earnings in target capital structure.
Retained earnings for the period equals $21,000,000 (i.e. $30,000,000 × (1 – 30%)).
|Break Point =||$21,000,000||= $46.67 million|
The new marginal cost of capital once $46.67 million of capital is raised is 12%.
Using the above data, the marginal cost of capital curve can be graphed as follows:
Investment Opportunity Schedule
Investment opportunity schedule is the table/graph of cumulative investment opportunities and their expected return. It plots the expected return on the Y-axis and the initial investment required on the X-axis.
Let’s say the following is a list of potential investment opportunities available to your company and their expected return:
|Project||Initial Investment||Expected Return|
The investment opportunity schedule can be plotted as follows:
Marginal cost of capital (Ali)
After reading this article you will learn about the Computation of Marginal Cost of Capital.
Sometimes, we may be required to calculate the cost of additional funds to be raised, called the marginal cost of capital. The marginal cost of capital is the weighted average cost of new capital calculated by using the marginal weights. The marginal weights represent the proportion of various sources of funds to be employed in raising additional funds.
In case, a firm employs the existing proportion of capital structure and the component costs remain the same the marginal cost of capital shall be equal to the weighted average cost of capital. But in practice, the proportion and/or the component costs may change for additional funds to be raised.
Under this situation, the marginal cost of capital shall not be equal to the weighted average cost of capital. However, the marginal cost of capital concept ignores the long-term implications of the new financing plans, and thus, weighted average cost of capital should be preferred for maximisation of shareholder’s wealth in the long-run.
A firm has the following capital structure and after-tax costs for the different sources of funds used:
(a) Calculate the weighted average cost of capital using hook-value weights.
(b) The firm wishes to raise further Rs. 6,00,000 for the expansion of the project as below
Assuming that specific costs do not change, compute the weighted marginal cost of capital.
Optimal Capital Budget
A company’s optimal capital budget is the point at which its marginal cost of capital equals the incremental expected return. A company should raise new capital as long as the marginal cost of capital is lower than or equal to the available return.
The following chart plots the marginal cost of capital and investment opportunity schedule. The point of intersection of the marginal cost of capital curve and investment opportunity schedule is the optimal capital budget.
by Obaidullah Jan, ACA, CFA and last modified on Apr 17, 2019