Project Cost Analysis for Marginal Cost of Capital | CFA Level 1 Exam Preparation

Determining Project Size without Increasing Marginal Cost of Capital

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Question

Jacobi Lefebre, CFA, recently accepted a position in the Real Estate Strategy group of a large retail company. The Director of the group walks by Lefebre's cubicle, hands him a report with the following information, and asks Lefebre to determine how large a project the firm can undertake without increasing the marginal cost of capital.

The firm can undertake a project costing up to approximately:

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A. B. C. D.

Explanation

This question is asking you to calculate the retained earnings break even point BPRE(in relation to the marginal cost of capital). Once the breakeven point is reached, the firm will have to use external equity to fund projects, thus increasing the weighted average cost of capital (WACC).

The break point on the marginal cost curve is given by:

BPRE= (Retained Earnings) / (Equity Fraction, we)

Here, RE = earnings * (1 "" Payout) = $50 million * (1 "" 0.35) = $ 32.5 million,

And BPRE= $32.5 million / 0.60 = $54.17 million, or approximately $54 million.

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