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Gleim CIA Review Part 3

16th Edition, 1st Printing October 2012 NOTE: Text that should be deleted from the outline is displayed with a line through the text. New text is shown with a blue background. Study Unit 6 Managerial Accounting Page 252, Subunit 6.4., 6.b. and c.: This edit changes the new cost of capital rates to match the graph in the outline.
b. The marginal cost of capital (MCC) function can be combined with the IOS to identify the projects to be accepted. EXAMPLE of Capital Rationing
The entity can raise US $5.5 million of new capital at a cost of 10 9%. Any additional capital will cost 11.5%.

Figure 6-9 The IRRs of Projects A and D are higher than the cost of the required capital and should be accepted. The IRR of Project B is below the cost of the required capital and should be rejected. Project C cannot be entirely funded at the acceptable rate and also is rejected.

c. A basic principle in economics is that a firm should increase output until marginal revenue equals marginal cost. Greater output would reduce profits, and lower output would forgo profits. 1) In capital budgeting, MCC and the IOS rate are analogous to marginal cost and marginal revenue, respectively. That is why Project C as well as Project B are rejected. Project C can be only partially funded using 10 9% capital, so MCC exceeds the IOS rate. Thus, the entity should seek alternative investments for which MCC equals the IOS rate.

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