Question

Emmerson is the newly promoted controller for Blippi Consulting. The board has asked her to look into raising more money to design four new playground sets to be sold at Home Depot stores. One board director has asked her to explain if taking on new projects always increases the firm’s marginal cost of capital. Provide an answer.

Answer 1

Marginal cost of capital is the cost that is applicable for the next dollar of financing. The cost of capital depends on the sources of funds and the risk attached with the project for which the fund is being raised. It is not necessarily true that while taking the new project the firm’s marginal cost will increase. What happens is if the risk of the firm and the project is directly associated with the cost of capital. So if a company which is taking up a new project and it does not have good creditworthiness in the market then it will have to increase the interest that it is paying to the investors because investors believe that since the firm is already not in good financial condition and it is taking up projects which are risky so the possibility of the firm being turned around is low and their investment is at high risk so the marginal cost of capital for the project would be high but if the firm has high creditworthiness in the market and the project it is taking up is not very risky and it is highly probable that the project will bring significant amount of cash flows to the company then the marginal cost of capital for the funds might fall also not necessarily increase. So, the cost depends on the source of funds and the level of risk associated with the firm and project.