A MARGINAL COST OF CAPITAL REALITY CHECK: LENDER RATE SPECIFICATIONS

Traditional treatment of the marginal cost of capital comes under question when lenders are able to negotiate various features of debt contracts. The specified rate of interest is only one among many features determining the borrower's cost of funding. In addition, lenders usually require financial projections for a firm's expansion plans, because they want to assess exacting degrees of risk associated with those expansions. The traditional textbook model of marginal cost of capital makes the grand assumption that the projects under consideration are of average risk for the firm (they would not appreciably change the firm's overall risk complexion), and that increases in the weighted average cost of capital (WACC) are due to scale increases only. Firms are assumed to utilize cheaper sources of component funding f irst, accepting h igher co st al ternative financing o nly after the cheaper sourc es are exhausted. The real world, however, effectively refutes these assumptions when a firm's projects would change its risk complexion. This paper presents a method of exposition of the risk assessment process from the lender's point of view. The le nder's behavior may d irectly affect a corporate borrower's determination of their own marginal cost of capital in the case of expansion projects that will change the firm's overall risk complexion.