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Optimal Capital Budget

By Yuriy Smirnov Ph.D.

Definition

The optimal capital budget is an amount of investment that allows shareholder value to be maximized. It can be determined by plotting the marginal cost of capital (MCC) schedule and the investment opportunity schedule (IOS) in the same graph. The intersection point of the MCC curve and the IOS curve is the optimal capital budget.

Example

A company is considering the capital budget for the next financial year. The investment opportunity schedule is shown in the table below.

Let’s plot the investment opportunity schedule.

Investment opportunity schedule

As we can see, Project A has the highest priority and Project C the lowest. A company will need to raise additional capital of $26,619,000 to undertake all five projects.

In turn, the Treasury Department prepared the following schedule of a company’s cost of capital, assuming that the target capital structure is 40% of debt and 60% of equity.

The weighted marginal cost of capital (WMCC) of the first $9,000,000 ($3,600,000+$5,400,000) is 10.40%.

WMCC = 0.4×5.00% + 0.6×14.00% = 10.40%

The company can then raise another $10,500,000, i.e., $4,200,000 of debt ($7,800,000-$3,600,000) and $6,300,000 of equity ($11,700,000-$5,400,000).

WMCC = 0.4×6.25% + 0.6×16.50% = 12.40%

Finally, the company can raise the last $8,500,000, i.e., $3,400,000 of debt ($11,200,000-$7,800,000) and $5,100,000 of equity ($16,800,000-$11,700,000).

WMCC = 0.4×8.50% + 0.6×21.50% = 16.30%

Now the marginal cost of capital schedule can be plotted.

Marginal cost of capital schedule

Graph

The optimal capital budget can be determined by plotting the investment opportunity schedule and the marginal cost of capital schedule in one graph as illustrated below.

Optimal capital budget

The point of intersection of the MCC curve and the IRR curve indicates that the company should undertake Project A, Project G, and Project E because their internal rate of return exceeds the marginal cost of capital. Project B and Project C must be rejected since their IRR is lower than the MCC; hence, they have a negative net present value (NPV).

Thus, the optimal capital budget for the next financial year is $17,913,000, i.e., the sum of the initial cost of Project A, Project G, and Project E. If the company undertakes these three projects, shareholder value will be maximized.