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Unit 11: Project Cash Flow

it does not know if all the projects will be able to generate a high enough return (i.e. IRR) to Notes
cover the cost of raising the new capital. In order to make the correct decisions, Microsoft needs
to combine its IOS with its MCC schedule to determine which project it should undertake and
which project it should reject.

11.6.2 Combining the MCC and IOS Schedules

A financial manager will continue to accept project as long as the marginal return generated by
the project is higher than the marginal cost the firm needs to pay to finance it. The financial
manager will stop accepting projects once the marginal return generated by the project is exactly
offset by the marginal cost faced by the firm. This is the point where the IOS and MCC schedule
of the firm intersects.
The intersection point indicates the marginal cost of capital faced by the firm. In other words, the
cost the firm will have to pay if it decides to raise one additional dollar. This is usually the rate
the firm uses to evaluate its average risk projects (i.e. finding the NPVs).
The marginal cost of capital a firm faced depends on the availability of projects. If the firm has
fewer available projects, the IOS will shift to the left and the firm will face a lower marginal cost.
Whereas an increase in available projects will shift the IOS to the right, and this will raise the
marginal cost.
The following figure shows the MCC schedule and IOS of a particular firm. The IOS indicates
that the firm faces five potential projects, and its MCC schedule indicates the firm will experience
a break point (most probably when it exhausts its retained earnings). From the graph below, we
know from the intersection of the firm’s IOS and MCC schedule that the marginal cost of capital
for the firm is 15.5%. The firm will use this marginal cost of capital to pick its projects. From our
earlier discussion, we know a firm will pick a project only if its IRR is greater than its cost of
capital. In this particular case, the firm will pick projects A, B and C (and rejects projects D and E).
In addition, we know the optimal capital budget for the firm is $150 million.

Figure 11.3: Depiction of MCC Schedule and IOS
WACC
A=18%

B=17%
C=16%

15.5% MCC
D=14%
E=13%
IOS

$150M Amount of Financing

Example: The financial manager of Surf the Net, Inc. (STN) is planning next year’s capital
budget. STN expects its net income to be $2,700,000 next year, and its payout ratio is 30%. The
company’s earnings and dividends are growing at a constant rate of 8%; the last dividend, D ,
0
was $1.00; and the current equilibrium stock price is $16. STN can raise up to $1,800,000 of debt

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