Marginal Cost of Capital (Definition, Formula)

What is the Marginal Cost of Capital?

Marginal Cost of Capital is the total combined cost of debt, equity, and preference taking into account their respective weights in the total capital of the company where such cost shall denote the cost of raising any additional capital for the organization which aides in analyzing various alternatives of financing as well as decision making.

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 * After-Tax Cost of Source₁) + (Proportion of Source₂ * After-Tax Cost of Source₂) +….+ (Proportion of Source * After-Tax Cost of Source)

Examples

You can download this Marginal Cost of Capital Excel Template here – Marginal Cost of Capital Excel Template

Example #1

Company present capital structure has funds from three different sources i.e., equity capital, preference share capital and the debt. Now the company wants to expand its current business and for that purpose, it wants to raise the funds of $ 100,000. The company decided to raise capital by issuing equity in the market as according to the present situation of a company it is more feasible for the company to raise capital through the issue of equity capital rather than the 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 dollar of a fund by the way of equity, debt, etc. In the present case, the company raised the funds by issuing the additional equity shares in the market for $ 100,000 cost of which is 10 % so the marginal cost of capital of the raising of 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.

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The firm wants to further raise the capital of $ 800,000 as it is planning to expand its project. Below are the details of the sources from which the capital is raised. The after-tax cost of debt will remain the same as present in the existing structure. Calculate the marginal cost of capital of the company.

Solution:

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 given excel template above for detail calculation.

Advantages

Some of the advantages are as follows:

It aims in the change of overall cost of capital because of the raising of one more dollar of the fund.
It helps in decision making whether or not to raise further funds for business expansion or new projects by discounting the future cash flows with a new cost of capital.
It helps in deciding by what means the new funds to be raised and in which proportion.

Disadvantages

Some of the disadvantages are as follows:

It ignores the long term implications of raising a new fund.
It doesn’t aim at maximization of shareholder’s wealth unlike the weighted average cost of capital.
This concept can’t 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 the way of equity, debt, etc. It is the combined rate of return required by the debt holders and shareholders for the financing of additional funds of the company.

The marginal cost of capital will increase in slabs and not linearly reason being a company may decide of financing a defined portion of new investment by re-investing the earnings or raising the majority by debt and/or preference share so as it can maintain the target capital structure. What is to be noted that the re-investment of earnings can be done without hampering the cost of equity. But as and when the proposed capital exceeds the consolidated amount of retained earnings and debt and/or preferred stocks which are being raised in order to maintain the target capital structure, the cost of capital will also get increased.

Conclusion

It is the weighted average cost of the new proposed capital funding calculated by using their corresponding weights. The marginal weight implies the weight of that additional source of funds among the entire proposed funding. In case if any company decides to raise additional fund through various sources through which already funding have been done earlier and the additional raising of the fund will be in the same ratio as they were earlier existing then the marginal cost of capital will be same as that of the weighted average cost of capital.

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