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.”