By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.
Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.
If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).
All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.
It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).
ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.
What are the weights that ABC will have for each source of capital?
Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.
Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).
$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)
Therefore, the weights are as follows:
Long-term debt – 40%
Retained earnings – 35%
Common stock – 30%