Capital investment and non-constant marginal cost of capital

Abstract

Business practice and prior research in capital budgeting both establish that a firm’s marginal cost of capital (MCC) is not constant across the scope of its investments. Capital budgeting decision methodology in textbooks and in practice, however, does not address the full implications of capital budgeting decisions made under a non-constant MCC paradigm. An endogeneity problem arises naturally due to the presence of a non-constant MCC. In order to value a project, it is necessary to determine the appropriate cost of capital. However, in order to determine the appropriate cost of capital, a project must be ranked in order to determine where the project is found on the MCC schedule. We establish a net present value (NPV) maximizing methodology that fully resolves this problem. We demonstrate, using a Monte Carlo simulation, the potential magnitude of investment errors and the extent of shareholder wealth destruction that occurs when commonly used methods or simplifying assumptions are employed in place of using this optimizing approach.