“lumpiness” of security issuance (?.?)

Question

Hi All,

Could anyone please explain to me on below -->
C is incorrect. A company does not necessarily raise more funds according to its target capital structure because of the economies of scale in raising new capital and market conditions. These short-run deviations are due to the “lumpiness” of security issuance. The marginal cost of capital may increase, reflecting these deviations.
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Question:
Which of the following situations is the least likely reason why the marginal cost of capital schedule for a company rises as additional funds are raised?

The company seeks to issue less senior debt because it violates the debt incurrence test of an existing debt covenant.
 	The cost of additional funds from various sources rises as higher levels of financing are achieved.
 	The company deviates from its target capital structure because of the economies of scale associated with flotation costs and market conditions.

Solution
B is correct. The WACC does not necessarily increase as more funds are being raised. Higher amounts of funding would not change the WACC if everything were in proportion to the old target capital structure. It is the changes in relative proportions of sources of funding that could make a difference because of interest deductibility and financial risk.

A is incorrect. The debt incurrence test may restrict a company’s ability to incur additional debt at the same seniority based on financial tests or conditions. They will have to issue a less senior debt (or even equity) which would have higher cost.

C is incorrect. A company does not necessarily raise more funds according to its target capital structure because of the economies of scale in raising new capital and market conditions. These short-run deviations are due to the “lumpiness” of security issuance. The marginal cost of capital may increase, reflecting these deviations.

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Thank you!

Zee Tan · Answer

A company issues new shares and buys back shares not as an ongoing and continuous process, but rather in discrete events, hence described here as "lumpy".

Discrete security issuance and buybacks result in step-changes (rather than continuous, smooth changes) in the equity structure and short-term WACC deviations.