WACC vs MCC

Hi,

Was wondering what the difference is between the marginal cost of capital (MCC) and the weighted average cost of capital?

So when do companies use the MCC and when do they use the WACC?

When determining the optimal capital budget (using the investment opportunity schedule), do we use the MCC or WACC to determine when they intersect?

I know this question was asked numerous times before (and for good reason, given that the Curriculum and Prep Providers don’t clarify the theory), but the prior threads provide conflicting answers.

Also, how/why does the WACC represent the risk of an “average” project? Is it because the sources of capital are used to fund many different projects of varying risk levels and thus the weighted cost of capital “averages out” the risk to a certain value that we know to be the WACC?

Thanks all.

Not sure about MCC vs WACC.

I don’t think WACC represents the risk of an “average” project. It only helps when evaluating projects because WACC is used as the discount rate when doing NPV analysis on a project. The reason why WACC is used is because it is the the required rate of return (or hurdle rate) demanded by both debt and equity holders. If you look closer at WACC, it only describes the the combined required returns of debt and equity wile taking into account the weights from debt and equity.

Bump.

WACC is the average cost of capital which a firm must cover on a minimum in order to make money on the project.

Essentially WACC provides you the guidance that the minimum return firm needs to make after allowing it to make its equity/debt payments to financiers of the project.

MCC is essentially the relationship of WACC to the cost of the project, which is a curve that moves.

Hope that helps

Was wondering what the difference is between the marginal cost of capital (MCC) and the weighted average cost of capital?

The MCC is the cost (i.e. the rate) a firm would pay for NEW (i.e. “marginal”) financing. In practice, this is often approximated by the WACC. In other words, it assumes that the cost of financing doesn’t change from before.

So when do companies use the MCC and when do they use the WACC?

If the cost of financing doesn’t change and the project has the same risk as the “average” project of the firm, they’re the same.

When determining the optimal capital budget (using the investment opportunity schedule), do we use the MCC or WACC to determine when they intersect?

In a question regarding the “optimal” capital budget, use the intersection of the MCC and the IOS.

Also, how/why does the WACC represent the risk of an “average” project?

We don’t directly observe the WACC. In practice, we use the following intuition to estimate it. Assume we bought all the debt and equity of the firm. In that case, we’d receive all the cash flows that the firm’s projects generated. So, in some sense, we’d have the “average” project of the firm. Since our value-cap-weighted portfolio of debt and equity has the same pattern of cash flows as the average project, it has the same risk (and therefore must have the same required rate of return) as that average project.

Unfortunately, we don’t have “market prices” for the firm’s projects. But we DO for our portfolio. So, we use them to calculate the required return for the average project.

In short, we can’t use capital markets to directly get prices/required returns for the average project, so we create something that mimics it and use capital markets to price that.

It’s like the old line: “If it walks like a duck, quacks like a duck, and waddles like a duck, no matter what you call it, it’s a duck.”

In the case of WACC, the saying would be “If it has the same cash flows as a duck, it has the same required rate of return as a duck.”

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Last Fall was my first semester teaching mathematics at Chapman University. On the day that one of the full-time professors was in my classroom for my mandatory evaluation, we were discussing Leibniz’ notation for the derivative of y with respect to x: dy/dx. I explained that, although the notation looks like a fraction, it, in fact, is not a fraction; however, under certain circumstances it acts like a fraction.

So I asked, “If it looks like a duck, and walks like a duck, and sounds like a duck, and smells like a duck, and feels like a duck, and tastes like a duck, then . . . ?”

One of the students replied, “It’s a duck.”

I yelled (literally yelled, very loudly), “No! I just got through telling you that _ it is not a duck! _”

Then, quietly, “But you should treat it like a duck.”

The professor likes my exuberance.

Oops. To be precise, I should have said, “it’s EFFECTIVELY a duck”.

I made it as simple as possible, but too simple.