The marginal cost of capital: a portfolio theory perspective

Markowitz's portfolio theory is shown to have profound implications for one of the core issues in corporate finance: the marginal cost of capital. Most researchers and practitioners would agree that if a firm's projects are all similar, they should all be discounted at the same marginal cost of capital (MCC), which is also the firm's average cost of capital (ACC). However, when a firm expands by accepting a new project, its weight in investors' portfolios increases, and investors will be willing to accept this only if the firm's expected return increases. Thus, the new project's MCC must be higher than the ACC. We derive the MCC in a portfolio context. The difference between the MCC and the ACC is economically significant for large and volatile firms, and for firms that are not widely held. The portfolio theory perspective provides a unified explanation for the price reaction to SEOs, IPOs, and stock repurchases.