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# Calculating the Amount the MCC Changes

We’ve identified two breakpoints at which the firm’s MCC will change:

BPd= 750 000; BPs =1 200 000

Since the MCC is simply the weighted average cost of the next dollar of capital to be raised, we can use the WACC formula.

We assume that Ellis Industries wants to maintain its current capital structure of 40% debt, 10% preferred stock, and 50% common equity.

Then,

МСС up to BPd (750 000) = (0.4 × AT rd) + (0.1 × rp) + (0.5 × rs) = (0.4 × 0.06) + (0.1 × 0.125) + (0.5 × 0.155) = 0.114 = 11.4%

We see from our calculations that up to the first breakpoint, the Ellis MCC is 11.4 percent - the WACC we calculated earlier. We know, however, that the Ellis lenders will raise the interest rate to 10% if the firm raises more than \$750 000, at which point the AT rdincrease from 6% to 7.2%.

Then,

МСС between BPd (750 000) and BPs (1 200 000) = (0.4 × AT rd) + (0.1 × rp) + (0.5 × rs) = (0.4 × 0.072) + (0.1 × 0.125) + (0.5 × 0.155) = 0.1188 = 11.88%

At the second breakpoint, BPs, we know from our earlier Ellis calculations that rsof 15.5% changes to rn that has a value of 16.05%.

Then,

МСС over BPs (1 200 000) = (0.4 × AT rd) + (0.1 × rp) + (0.5 × rs) = (0.4 × 0.072) + (0.1 × 0.125) + (0.5 × 0.1605) = 0.1216 = 12.16%.

A graph of Ellis’ MCC is shown below:

 18% 17% 16% 15% 14% 13% 12.16% 12 % 11.88 % 11.4% 11 % 10 % 9%

0                    \$500 000                 \$1 000 000              \$1 500 000

The MCC Schedule and Capital Budgeting Decisions

Firms use the MCC schedule to identify which new capital budgeting projects should be selected for further consideration and which should be rejected.

For example, Ellis Industries has identified the following projects for possible adoption:

 Projects Initial Investment Required Project’s IRR, % A 500 000 18 B 300 000 14 C 200 000 12.05 D 300 000 11.50 E 200 000 9

The projects are ranked from highest to lowest IRR. The list of proposed capital budgeting projects ranked by IRR is the firm’s investment opportunity schedule (IOS).

To compare the project’s IRRs to the firm’s cost of capital, the financial managers plot the IOS on the same graph as the MCC.

The projects with the highest IRR are plotted first. The Ellis financial managers should start with Project A, which has an IRR of 18%. That project requires a capital investment of \$500 000. Next, they should add Project B, a project with an IRR of 14% and an investment of \$300 000. the total capital budget with Project A and B is \$800 000. Then Project C, with an IRR of 12.05%, should be added. Project C’s investment requirement of \$200 000 increases the capital budget to \$1 000 000.

The addition of Project D, a project with an IRR of 11.5% and investment of \$300 000, results in a capital budget to \$1 300 000. Because the Project D’s IRR is less than the MCC, the company should reject it. Project E, a project with an even lower IRR, is also rejected.

 18% Project A, IRR=18% 17% 16% 15% Project B, IRR=14% 14% 13% Project C, IRR = 12.05% 12.16% 12% 11.88% Project D, IRR=11.5% 11.4% 11% 10% Project E 9%

0       \$500 000              \$1 000 000              \$1 500 000

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