8.3 Marginal Cost of Capital

The marginal cost of capital 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 capital budgeting decisions.

Unlike the weighted average cost of capital, 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

• 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:
     • Cost of debt: $k_d = \frac{Interest}{Net \space proceeds} \times (1 - t)$, where $t$ is the marginal tax rate
     • Cost of preferred stock: $k_p = \frac{Preferred \space dividends}{Net \space proceeds}$
     • Cost of common stock: $k_s = \frac{D_1}{P_0} + g$ (dividend growth model) or $k_s = R_f + \beta(R_m - R_f)$ (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 net present value (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