Break point

Breakpoint


Related to the Weighted Marginal Cost of Capital (WMCC) concept is the break point concept. Break point is the amount of total financing at which the cost of one of the components of total financing escalates. At such point WMCC also increases. Calculation of the break point is required for calculation of the weighted marginal cost of capital (WMCC).

For example, if a business used up all retained earnings to issue common stock and it still requires more financing, it may issue new common stock. The cost of new common stock is higher due to under pricing and flotation costs. Therefore, the cost of one of the financing components rises and consequently WACC also rises and WMCC also escalates. The point at which the cost of one of the components rises is called the break point.

To find a break point for a particular financing source, we need to take the amount of funds available from the financing source at a given cost and divide it by the capital structure weight for the financing source.

Break Point = funds from the financing source/capital structure weight.

Example


Assume that when the business uses up $100,000 of its long-term debt at a cost of 7%, it can only use long-term debt at a cost of 10%. The weight of a long-term debt as a source of capital in the company’s capital structure is 40%. To find the break point we take $100,000 and divide it by 0.4. We end up with $250,000, which is a break point.

Test yourself


ABC Corporation has a long-term debt weight of 35% and the equity weight of 65% in the capital structure. The business has $400,000 of retained earnings left at a cost of 12%. Thereafter, they can issue new common stock at a cost of 17%. ABC can use long-term debt as a source of financing up to the amount of $200,000 at 8% and thereafter at 10%.

REQUIRED: What are the break points for debt and equity?

SOLUTION:

Debt break point:

200,000/.35=$571,428.65

Equity break point:

400,000/.65=$615,384.6

Therefore, at total new funding levels of $571,428.65 and $615,384.6 the WMCC will shift upward.

Related articles: Weighted average cost of capital (WACC), Weighted Marginal Cost of Capital

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