The marginal cost of capital (MCC) is the total combined cost of debt, equity, and preference shares, taking into account their respective weights in the company’s total value. This cost represents the expense of raising additional capital for the organization, aiding in analyzing various financing alternatives and making informed decisions. MCC, also known as the Opportunity Cost of Capital (OCC) or Weighted Average Cost of Capital (WACC), indicates how much a company pays for financing. It helps determine the required return for investment projects.
The cost of different sources of capital changes as a company raises additional funds, leading to variations in its weighted average cost of capital (WACC). 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 within the total proposed budget. If a company raises funds through multiple sources, the additional funds will generally be raised in the same ratio as before. Therefore, the marginal cost of capital will initially align with the WACC, which is the average cost of using both equity and debt, weighted by their respective proportions in the capital structure.
However, the marginal cost of capital does not increase linearly; rather, it increases in slabs. This means that as a company raises more funds, the cost of raising additional capital will increase at a non-linear rate. The calculation and evaluation of MCC can vary depending on factors such as the type of company operations, industry sector, and current market conditions. Since the financial landscape is continuously evolving, it is essential to use updated data for accurate calculations. In reality, when a company raises additional funds with different components or weightings, the marginal cost of capital may differ from the WACC.
When an organization seeks to raise capital, it must assess whether the new investment will generate returns greater than the marginal cost of capital. If the returns exceed the MCC, the investment decision is considered profitable and adds value for stakeholders. Conversely, if the returns are lower than the MCC, it may not be a wise financial decision for the company.
Example 1:
A company’s present capital structure comprises equity shares, preference shares, and debt totaling Rs. 10 million. Given the company’s current situation, it is more feasible to raise additional capital through the issuance of equity rather than debt or preference shares. In this scenario, the marginal cost of capital for expansion is 10%.
Example 2:
Consider the following sources of additional capital and their after-tax costs:
- 50% of additional capital at an after-tax interest rate of 15%
- 25% of additional capital at an after-tax interest rate of 10%
- 25% of additional capital at an after-tax interest rate of 8%
The weighted marginal cost of capital (WMCC) formula is used when new funds are raised from multiple sources and is calculated as follows:
Formula:
Weighted Marginal Cost of Capital = (Proportion of Source1 × After-Tax Cost of Source1) + (Proportion of Source2 × After-Tax Cost of Source2) +…. + (Proportion of Source “x” After-Tax Cost of Source)
Calculation:
WMCC = (50%× 15%) + (25%× 10%) + (25% × 8%)
WMCC = 7.50% + 2.50% + 2.00%
WMCC = 12%.
Thus, the weighted marginal cost of capital in this example is 12%.
