## Marginal Cost of Capital (MACC) and Breaking Points

As a firm raises progressively more capital, cheaper internal sources (retained earnings) get exhausted. The firm must then issue new equity at flotation cost. The cost of each additional rupee — the marginal cost of capital — rises at these breaking points.

### Breaking Point Formula

BP = Maximum amount of cheaper source / Its proportion in target capital structure

For retained earnings:

BP_RE = Available retained earnings / Equity weight

Below BP: use cost of retained earnings (Kr)

Above BP: use cost of new equity (Ke_new, which includes flotation cost)

### Debt Breaking Point

If debt has tiered costs (e.g., cheaper up to ₹X, costlier beyond):

BP_debt = Maximum cheap debt / Debt weight

### Marginal WACC Schedule

1. List all sources and their costs at different funding levels

2. Compute breaking points for each source that changes cost

3. WACC₁ applies up to first BP; WACC₂ above first BP; and so on

### Standard Exam Structure

(A) Compute after-tax costs of new debt, new preference, and equity (from retained earnings)

(B) MACC when no new equity is needed (using Kr)

(D) MACC beyond breaking point (using Ke_new at flotation-adjusted NP)

Worked example

### Example 1

Q54 — ABC Ltd: full marginal cost schedule (Study Material)

Capital structure: 14% Deb ₹30,000 (15%); 11% Pref ₹10,000 (5%); Equity ₹1,60,000 (80%). Tax = 50%.

EPS trend: grows from ₹1.00 (2001) to ₹2.36 (2010) — 9 years

g: (2.36/1.00)^(1/9) – 1 ≈ 10% (check: 1.00 × 1.10⁹ ≈ 2.358 ✓)

(A) Component costs:

(i) New 16% debentures, market ₹96 → NP = ₹96 (use market as net proceeds), RV = ₹100 (par)

Kd = [16×0.50 + (100–96)/n] / [(100+96)/2] ≈ 8/96 = 8.33% (perpetual approx for irredeemable; if redeemable use n)

Actually, for new debentures at NP = ₹96, coupon 16%, redeemable at par:

Approx Kd ≈ [8 + small amortisation] / 98 ≈ 8.42%

(ii) New 11% pref at ₹9.20, D = ₹1.10:

Kp = 1.10 / 9.20 = 11.96%

(iii) Equity from retained earnings: D₁ = 50% × ₹2.36 = ₹1.18; P₀ = ₹23.60

Kr = 1.18/23.60 + 0.10 = 5% + 10% = 15%

(B) MACC (no new shares):

= 0.15×8.42 + 0.05×11.96 + 0.80×15

= 1.26 + 0.60 + 12.00 = 13.86%

Retained earnings available = 50% × 2010 EPS × shares = 50% × 2.36 × 10,000 = ₹11,800

BP = 11,800 / 0.80 = ₹14,750

(D) MACC beyond BP (new equity at ₹20 net):

Ke_new = 1.18/20 + 0.10 = 5.9% + 10% = 15.9%

New MACC = 0.15×8.42 + 0.05×11.96 + 0.80×15.9

= 1.26 + 0.60 + 12.72 = 14.58%

### Example 2

Q44 — ABC Ltd: additional debt with tiered cost (PYQ)

Additional finance needed = ₹20L; D:E = 25:75; RE available = ₹4L; Tax = 30%; Personal tax = 20%

Equity needed = 75% × 20 = ₹15L → RE covers ₹4L → New equity = ₹11L

Debt needed = 25% × 20 = ₹5L

(i) Average after-tax cost of debt:

First ₹2L @ 10%: Kd = 10×0.70 = 7%

Next ₹3L @ 13%: Kd = 13×0.70 = 9.10%

Weighted avg = (2×7 + 3×9.10)/5 = (14+27.3)/5 = 8.26%

(ii) Ke = (EPS×payout)/P₀ + g = (12×0.50)/60 + 0.10 = 10% + 10% = 20%

Kr = 20% × (1–0.20) = 16% (personal tax adjustment)

(iii) Overall WACC on ₹20L additional:

= (4/20)×16 + (11/20)×20 + (5/20)×8.26

= 3.20 + 11.00 + 2.065 = 16.265%

⚠️ Common exam mistakes

Dividing available retained earnings by total new capital (not by the equity proportion) — the BP formula divides by the equity weight, not 1.
Computing the breaking point in rupees and stopping there instead of calculating the new MACC beyond the BP.
Forgetting that Kr < Ke_new — below the BP, retained earnings are used (cheaper); above the BP, new equity is issued (more expensive due to flotation).
For tiered debt, not computing a weighted average cost across the tiers — each tranche has a different after-tax cost.

Reference:

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Marginal Cost of Capital and Breaking Points

Worked example

⚠️ Common exam mistakes