 By marginal cost of capital we mean the additional cost of capital that a firm is incurring while the firm raises some additional funds in order to meet its certain financial needs. We know that the weighted average cost of capital changes as the capital structure changes in order to raise of the fund by the company. There are two reasons of this change in the weighted average cost of capital. The first reason is that where a company with existing debt having any covenants then the company may be restricted from issuing a debt with similar seniority or similar features borne by the existing debt. The other reasons of change in weight is that the deviation from the target capital structure because of the consideration of economies of scale in raising new funds, new capital and the market conditions. On the screen dear students you can see the graphical presentation of marginal cost of capital. You see that marginal cost of capital or MCC schedule which is the result of change in weight for different levels of financing. On the right panel in the bottom of the screen you can see that here we have the cost or the weight here we have the amount of new capital as we raises the amount of capital our cost of capital goes on decreasing and the vice versa is there. So we have an upward curve and this curve shows the relationship between WEG and the amount of new capital. This pictorial relationship between WEG and the additional capital is termed as the marginal cost of capital schedule. Now what is the break point? Break point basically is the amount of capital at which due to the additional capital issuance the company's WEG changes. In the left panel you can see the presentation of break point. In this pictorial diagram we see that here is the company's WEG and here is the amount of new capital. Now whenever there is a change in capital let's say from this point to this point there is an upward trend in the WEG so WEG increases again we have a certain change in capital then we have corresponding change in WEG to the point where there is a change these points are known as the break points because these are the points where the WEG changes due to the change in capital structure. Now we have a similar concept in both of the diagrams but we have different presentation of the curve in fact the reality of this raising capital is that the marginal cost of capital schedule which is a smoothing curve in this right panel is not as smooth as in the left panel. In fact this is the presentation of step up cost schedule because as we have some additional fund our cost steps up. Now we have an exercise to understand this break up point and the marginal cost of capital schedule it says that Alan wants to determine capital structure that will result in the lowest cost of capital for his company which is in the tax bracket of 36 percent. Alan has access to the following information the company can borrow a 12 month library which is 4.5 percent plus a premium varying with the debt to capital ratio the company market is premium the risk free rate and the unlivered beta is 4 percent 4.25 percent and 0.90 respectively the question one says determine WEG for level of debt equity ratio as under so we have certain debt equity ratios which is less which ranges from less than 40 percent to 90 percent or higher accordingly we have spread from 200 points to 1200 points in line with our debt equity ratio the question two is recommend a target capital structure given that the company is concerned with achieving the lowest possible cost of capital this means that we are to recommend a target capital structure at which the company is incurring the lowest possible cost of capital for question one we have a table developed for this purpose in first column we have our capital structure which ranges from a 10 percent of debt in the overall capital to 90 percent of debt in the overall capital in column two we have the corresponding values of beta in relation to the individual capital structure level then we have for each capital structure level the cost of debt and the corresponding cost of equity using these values in the model of WEG we can have the individual WEG for every capital structure in our example which starts from 7.7 percent to 12.4 percent at the 90 percent so this is the schedule where we have determined the WEG for each level of capital structure as an alternative the answer to the question is that we need to determine that optimal capital structure at which the company is incurring the lowest possible cost of capital if we see on the table then we can see that at a capital structure where the level of debt is 30 percent the capital the overall cost of capital is 7.4 percent which is the lowest possible in this schedule so here the optimal capital structure is 30 percent debt and 70 percent equity because at this capital structure of 30 70 the company is incurring the most possible lowest cost of capital which is 7.4 percent