What is the Marginal Cost of Capital?

Formula

Marginal Cost of Capital = Cost of Capital of Source of New Capital Raised

The weighted marginal cost of capital formula = It is calculated in case the new funds are raised from more than one source, and it is calculated as below: –

Weighted Marginal Cost of Capital = (Proportion of Source1 x After-Tax Cost of Source1) + (Proportion of Source2 x After-Tax Cost of Source2) +…. + (Proportion of Source x After-Tax Cost of Source)

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Examples

Example #1

A company’s present capital structure has funds from three different sources: equity capital, preference sharePreference ShareA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more capital, and debt. Now, the company wants to expand its current business. For that purpose, it intends to raise funds of $100,000. The company decided to raise capital by issuing equity in the market. According to the company’s present situation, it is more feasible to raise money through the issue of equity capitalEquity CapitalEquity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company.read more rather than debt or preference share capital. The cost of issuing equity is 10%. What is the marginal cost of capital?

Solution:

It is the cost of raising an additional fund dollar through equity, debt, etc. For example, in the present case, the company raised funds by issuing the additional equity shares in the market for a $100,000 cost of 10%, so the marginal cost of capital of raising new funds for the company will be 10%.

Example #2

The company has a capital structure and the after-tax cost as given below from different sources of funds.

The firm wants to raise the capital of $800,000 further as it plans to expand its project. Below are the details of the sources from which the money is raised. The after-tax cost of debt After-tax Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more will remain the same as in the existing structure. First, calculate the marginal cost of capital of the company.

Calculation of the weighted marginal cost of the capital: –

WMCC = (50% * 13%) + (25% * 10%) + (25% * 8%)

WMCC = 6.50% + 2.50% + 2.00%

WMCC = 11%.

Thus, the weighted marginal cost of the capital of raising new capital is 11%.

Please refer to the given Excel template above for detailed calculations.

Advantages

Some of the advantages are as follows:

  • It aims to change the overall cost of capital by raising one more dollar of the fund.It helps decide whether to raise further funds for business expansion or new projects by discounting the future cash flows with a new cost of capital.It helps decide the new funds to raise and in what proportion.

Disadvantages

Some of the disadvantages are as follows:

  • It ignores the long-term implications of raising a new fund.It does not aim to maximization of shareholder wealth, unlike the weighted average cost of capital.This concept cannot be applied to a new company.

Important Points

The marginal cost of capital is the cost of raising an additional dollar of a fund by way of equity, debt, etc. It is the combined rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more required by the debt holders and shareholders to finance additional funds for the company.

The marginal cost of capital will increase in slabs and not linearly. For example, a company may finance a defined portion of new investment by reinvesting the earnings or raising the majority by debt and/or preference share to maintain the target capital structure. One can do the reinvestment of earnings without hampering the cost of equity Cost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more. But, when the proposed capital exceeds the consolidated amount of retained earnings Retained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more and debt and/or preferred stocks raised to maintain the target capital structure, the cost of capital will also increase.

Conclusion

The weighted average cost of the new proposed capital funding is calculated using their corresponding weights. The marginal weight implies an additional source of funds among the total proposed budget. If any company decides to raise other funds through various sources, funding has already been done earlier. Therefore, the additional raising of the fund will be in the same ratio as earlier. Therefore, the marginal cost of capital will be the same as that of the weighted average cost of capital.

But in the real scenario, additional funds might be raised with different components and/or other weights. In this, the marginal cost of capital will not equal the weighted average cost.

This article is a guide to What is the Marginal Cost of Capital?. We discuss formulas, advantages, disadvantages, and examples of the marginal cost of capital. You can learn more about accounting from the following articles: –

  • Forfaiting DefinitionWhat is the Cost of Debt Formula?Formula of Cost of CapitalExamples of Opportunity Cost