Glossary

8.3 Marginal Cost of Capital

3 min read•july 18, 2024

The is crucial for evaluating new investment projects. It represents the cost of raising additional funds, helping firms determine if a project's returns exceed financing costs. This concept is key for making smart decisions.

Unlike the , which looks at existing financing, the marginal cost focuses on new capital. By constructing a marginal cost schedule, firms can see how costs change as they raise more money, guiding them in choosing the best financing options for projects.

Marginal Cost of Capital

Marginal cost of capital concept

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  • Marginal cost of capital (MCC) represents the cost of raising an additional dollar of capital for a firm
    • Calculated as the weighted average cost of the last dollar of new capital raised (debt or equity)
  • MCC plays a crucial role in capital budgeting decisions for evaluating investment projects
    • Determines the required rate of return for assessing the feasibility of new projects
    • Projects generating returns higher than the MCC are considered viable and create value for the firm (positive NPV)

Weighted average vs marginal cost

  • Weighted average cost of capital (WACC) represents the overall cost of a firm's existing capital structure
    • Calculated using the proportions and costs of debt and equity already in the firm's capital structure (historical)
  • Marginal cost of capital (MCC) focuses on the cost of raising new or additional capital for the firm
    • Reflects the cost of the next dollar of capital raised, which may differ from the existing WACC (forward-looking)
  • MCC is more relevant for evaluating new investment projects as it represents the current cost of raising incremental capital needed for financing the project

Construction of marginal cost schedule

  • A marginal cost of capital schedule shows the cost of raising additional capital at different levels of financing for a firm
  • Steps to construct an MCC schedule:
    1. Identify the firm's available financing options (debt, preferred stock, common stock)
    2. Determine the cost of each financing option:
      • : kd=InterestNet proceeds×(1−t)k_d = \frac{Interest}{Net \space proceeds} \times (1 - t), where tt is the marginal tax rate
      • Cost of preferred stock: kp=Preferred dividendsNet proceedsk_p = \frac{Preferred \space dividends}{Net \space proceeds}
      • Cost of common stock: ks=D1P0+gk_s = \frac{D_1}{P_0} + g (dividend growth model) or ks=Rf+β(Rm−Rf)k_s = R_f + \beta(R_m - R_f) (CAPM)
    3. Arrange the financing options in ascending order of their respective costs (cheapest to most expensive)
    4. Determine the amount of capital that can be raised from each financing source (debt capacity, stock issuance)
    5. Calculate the weighted average cost for each incremental level of financing (MCC at different capital levels)
  • The resulting MCC schedule shows the cost of capital for different levels of capital raised by the firm

Application in investment evaluation

  • Compare the internal rate of return (IRR) of an investment project with the marginal cost of capital (MCC)
    • If IRR > MCC, the project is feasible and should be accepted (generates returns above financing cost)
    • If IRR < MCC, the project is not feasible and should be rejected (returns insufficient to cover financing cost)
  • Use the (NPV) method with MCC as the discount rate for project cash flows
    • Calculate the present value of the project's cash flows using the MCC as the discount rate
    • If NPV > 0, the project is feasible and creates value for the firm (positive net value)
    • If NPV < 0, the project is not feasible and should be rejected (destroys value)
  • MCC helps ensure that the firm invests in projects that generate returns higher than the cost of raising additional capital to finance them

Key Terms to Review (16)

Beta: Beta is a measure of a stock's volatility in relation to the overall market, indicating how much the stock's price tends to move when the market moves. A beta greater than 1 signifies that the stock is more volatile than the market, while a beta less than 1 indicates lower volatility. Understanding beta helps investors assess risk and make informed decisions about portfolio management and investment strategies.
Capital Budgeting: Capital budgeting is the process of planning and evaluating long-term investments in assets and projects to determine their potential profitability and feasibility. This process is essential for financial management as it aligns investment decisions with the company’s strategic goals, taking into account the time value of money, risk, and cost of capital to optimize resource allocation.
CAPM - Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial formula used to determine the expected return on an investment, considering its risk in relation to the market. It highlights the relationship between systematic risk and expected return, allowing investors to make informed decisions about their portfolios based on the risk-reward trade-off. This model is crucial for assessing the marginal cost of capital, which helps firms understand the cost associated with obtaining new capital and making investment decisions.
Cost of Debt: Cost of debt refers to the effective rate that a company pays on its borrowed funds, typically represented as a percentage. This concept is crucial in understanding how companies finance their operations, as it directly impacts their overall cost of capital and profitability. By calculating the cost of debt, firms can make informed decisions about their capital structure, assess the impact of new financing options, and optimize their weighted average cost of capital (WACC).
Cost of equity: The cost of equity is the return that investors expect to earn on their investment in a company, reflecting the risk associated with owning the company's shares. This concept is vital as it influences a firm's investment decisions, financing strategies, and overall valuation. It serves as a benchmark for evaluating potential investments and affects how a company structures its capital, impacting its financial health and growth potential.
Expected return: Expected return is the anticipated return on an investment based on its probable outcomes, weighted by their respective probabilities. It provides a way to measure the potential profitability of an investment, incorporating both the risk and reward associated with it. Understanding expected return is crucial when analyzing various investment opportunities and constructing a balanced portfolio.
Financial Flexibility: Financial flexibility refers to a firm's ability to adapt its financial resources and structure to meet changing circumstances and opportunities. It encompasses the capacity to raise capital, adjust expenditures, and maintain liquidity in response to both internal and external pressures. This adaptability is crucial for firms as it enables them to respond effectively to market changes, pursue growth opportunities, and manage risks without facing undue financial strain.
Interest Rates: Interest rates are the cost of borrowing money or the return on savings, expressed as a percentage of the principal amount over a specific period. They play a crucial role in influencing economic activity, affecting spending and saving behaviors, and guiding monetary policy decisions.
Leverage: Leverage refers to the use of borrowed funds to amplify potential returns on investment. It plays a crucial role in finance as it allows companies to increase their investment capacity and potentially enhance profitability, but it also raises the risk of losses when investments do not perform as expected.
Marginal Cost of Capital: The marginal cost of capital refers to the cost of obtaining an additional dollar of capital, reflecting the risk and return expectations associated with new investments. This concept is crucial for making informed financing decisions, as it helps determine the optimal mix of debt and equity financing while considering the impact of financing costs on overall project viability.
Market conditions: Market conditions refer to the various factors and dynamics that influence the buying and selling of goods and services in a specific market. These conditions include elements such as supply and demand, competition, economic trends, and overall market sentiment. Understanding market conditions is crucial for assessing how they affect costs of capital and investment strategies.
Market Efficiency: Market efficiency refers to the extent to which asset prices reflect all available information. In an efficient market, securities are always priced appropriately based on their risk and expected returns, making it difficult for investors to consistently achieve higher returns than the market average without taking on additional risk. This concept connects deeply with how companies raise capital, how investments are evaluated, and how portfolios are managed over time.
Modigliani-Miller Theorem: The Modigliani-Miller Theorem is a foundational principle in finance that posits that, under certain conditions, the value of a firm is unaffected by its capital structure. This means that the mix of debt and equity used to finance a company does not influence its overall value, assuming no taxes, bankruptcy costs, or asymmetric information. This theorem helps in understanding how capital rationing, marginal cost of capital, capital structure theories, and leverage relate to firm valuation.
Net Present Value: Net Present Value (NPV) is a financial metric that calculates the difference between the present value of cash inflows and outflows over a specific period. It helps in evaluating the profitability of an investment by considering the time value of money, which means that money available now is worth more than the same amount in the future due to its potential earning capacity.
Risk premium: Risk premium refers to the additional return that investors expect to earn from an investment in exchange for taking on additional risk compared to a risk-free asset. It acts as a compensation for the uncertainty involved in investing, acknowledging that higher risks can lead to higher potential rewards. This concept is crucial in evaluating investment opportunities and determining expected returns, especially when considering the performance of individual assets versus a baseline, such as government bonds.
Weighted Average Cost of Capital: The weighted average cost of capital (WACC) is the average rate of return that a company is expected to pay its security holders to finance its assets, calculated by taking the cost of each capital component and weighting it based on its proportion in the overall capital structure. This concept is crucial for evaluating investment opportunities, determining optimal capital structures, and understanding the relationship between financial markets and a firm's overall performance.
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