Which of the following situations is the least likely reason why the marginal cost of capital schedule for a company rises as additional funds are raised?
(1).The company deviates from its target capital structure because of the economies of scale associated with flotation costs and market conditions. (2).The company seeks to issue less senior debt because it violates the debt incurrence test of an existing debt covenant. (3).The cost of additional funds from various sources rises as higher levels of financing are achieved.
The correct answer is 3, but I chose 1. Can anyone explain why 3 is correct and 1 is incorrect?
Thanks
Imagine the following circumstances for 1):
The company would like to be equally financed with debt and equity say it would like to raise $100,000 total (50k debt and 50k equity). However, flotation costs are so high (say $25,000 flat fee) that the company decides that as long as it pays that much to their Investment Bank they might as well raise a bit more (say $75,000 instead of $50,000). Now given that equity is more expensive, the company’s WACC (or marginal cost of capital) increases.
Regardging 3) (correct me if I am wrong here):
I think that as you reach higher financing levels your cost of additional funds for all sources should decrease. Imagine your company is a lemonade stand and at that stage nobody will lend you money or only at a VERY high interest rate given that you have no proven track record of a functioning business model (except for some form of trade credit from your parents, i.e. you pay them back for the lemons you used after you sold them). Later on as the company grows, you can apply for a bank loan. However as the company grows you will typically try to replace bank loans with commercial paper (that is, your company issues securities, short term debt, bonds, and the likes), which are typically cheaper. Also, I would expect that the equity that you sell, will be sold at a higher price than at the early stages (given that you have a proven track record of being able to sell lemonades, you can request more per share).
I agree with Tartaglia. This is taken straight from the study material:
“that have their own debt outstanding and parent holding companies that also issue debt, with different levels or rankings of seniority”
(Institute 587)
Institute, CFA. 2016 CFA Level I Volume 5 Equity and Fixed Income. CFA Institute, 07/2015. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
Basically levels and seniority are one and the same.
So basically, statement 3 is false. It’s a very sneaky question because answers 1 and 2 are true, while answer 3 is actually not true but it’s made to sound like the first two answers i.e. it’s just a true statement. Since this isn’t a true or false question (and it’s even emphasised as ‘which of these is least likely’ - so even the question makes you fall into the trap of assuming all three statements are indeed true and it makes you think that there’s nothing wrong with answer 3 but in actuality the statement makes no sense. The fact that they use synonyms (which I’m guessing are rarely used in the industry as such) to cleverly disguise the very basic principal of seniority makes this question is even harder.