LOS 48d Explain the analysts 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

A company increases its value and creates wealth tor its shareholders by earning more on its investment in assets than is required by those who provide the capital tor the firm. A firm's WACC may increase as larger amounts of capital are raised. Thus, its marginal cost of capital, the cost of raising additional capital, can increase as larger amounts are invested in new projects. This is illustrated by the upward sloping marginal cost of capital curve in Figure 1. Given the expected returns (IRRs) on potential projects, we can order the expenditures on additional projects from highest to lowest IRR. This will allow us to construct a downward sloping investment opportunity schedule such as that shown in Figure I .

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Figure 1: The Optimal Capital Budget

Project IRR Cost of Capital

Investment

Marginal Cost Capital Curve

Marginal Cost of Capital

Optimal capital budget

New capital raised/in vested ($)

The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the amount ot the optimal capital budget. The intuition here is that the firm should undertake all those projects with IRRs greater than the cost ot funds, the same criterion developed in the capital budgeting topic review. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of the additional capital required to fund them should be undertaken, as they will erode the value created by the firm.

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  • mike ackerman
    Why is investment opportunity schedule downwards sloping?
    8 years ago
  • Ruby
    Why investment opportunity schedule is downword sloping?
    8 years ago
  • Massawa Abaalom
    Why is the investment opportunity schedule downward sloping?
    8 years ago

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