Incremental cost of capital: what it is, how it works

Incremental Cost of Capital: What It Is, How It Works

The incremental cost of capital represents the cost of capital for each successive new unit of capital raised by a company. In the realm of corporate finance, it helps a business understand the financing expense associated with funding additional projects or expanding operations beyond its existing capital structure. This metric is crucial for sound capital budgeting and effective investment decisions, as it directly impacts the profitability and feasibility of new ventures.

Companies typically raise capital through various sources, primarily debt financing and equity financing. As a firm seeks more funds, the incremental cost of capital may change due to factors like increased risk perceptions by investors or the exhaustion of cheaper financing options. This concept is distinct from the average cost of all capital previously raised; instead, it focuses on the cost of the next dollar of capital.

History and Origin

The foundational understanding of the cost of capital, and by extension, the incremental cost of capital, is deeply rooted in financial theory developed in the mid-20th century. Early models focused on how a firm's capital structure influences its overall cost of financing. Academics like Franco Modigliani and Merton Miller made significant contributions, initially arguing that in perfect capital markets without taxes, a company's value, and thus its cost of capital, is independent of its capital structure. Their later work, notably "Corporate Income Taxes and the Cost of Capital: A Correction" in 1963, introduced the impact of corporate taxes, demonstrating how the tax deductibility of interest expenses could influence the cost of debt and subsequently the overall cost of capital⁴.

The idea of assessing costs incrementally stems from economic principles of marginal cost, where the focus is on the cost of producing one additional unit. Applied to finance, this means evaluating the cost of each additional increment of capital raised, acknowledging that different tranches of capital might come with varying expenses. This perspective became vital as companies grew and faced more complex financing scenarios beyond simple initial public offerings or bank loans.

Key Takeaways

• The incremental cost of capital measures the financing expense for each new, successive unit of capital a company raises.
• It is critical for evaluating new projects, as the appropriate discount rate for a new investment should reflect the cost of the specific capital used to fund it.
• As a company raises more capital, the incremental cost may increase due to higher risk premiums demanded by lenders and investors.
• This concept helps companies make optimal investment decisions by matching project returns with the true cost of their marginal funding.
• Ignoring the incremental cost of capital can lead to suboptimal capital allocation and a decrease in shareholder value.

Formula and Calculation

Calculating the incremental cost of capital involves determining the Weighted Average Cost of Capital (WACC) for the next block of financing. This means identifying the specific sources of new debt and equity, their respective costs, and their proportions in the new capital mix.

The general WACC formula is:

Where:

• (E) = Market value of equity
• (D) = Market value of debt
• (V) = Total market value of the firm (E + D)
• (Re) = Cost of equity for the new equity
• (Rd) = Cost of debt for the new debt
• (T) = Corporate tax rate

For the incremental cost, (Re) and (Rd) specifically refer to the marginal cost of raising additional equity and debt, respectively. For instance, if a company has exhausted its low-cost debt options and must issue new, higher-interest corporate bonds, that higher interest rate will be used for (Rd). Similarly, if issuing more shares would significantly dilute existing ownership, the required return on investment for new equity might increase.

Interpreting the Incremental Cost of Capital

Interpreting the incremental cost of capital involves assessing whether a new project's expected return surpasses this specific cost. If a project's projected returns exceed the incremental cost of the capital required to fund it, then undertaking that project would theoretically enhance shareholder wealth. Conversely, if the project's returns fall below the incremental cost, it would dilute value.

Businesses must compare the expected internal rate of return (IRR) of potential projects against the incremental cost of funding them. A firm's capital markets access and its current financial health heavily influence this cost. For example, a company with a strong credit rating might secure additional debt at a lower incremental cost than a highly leveraged company. The incremental cost of capital provides a tailored benchmark for evaluating new opportunities, reflecting the real cost of securing additional financial resources.

Hypothetical Example

Imagine TechInnovate, a growing software company, needs $10 million for a new research and development project. Their current capital structure has a Weighted Average Cost of Capital (WACC) of 8%. However, to raise this additional $10 million, they plan to issue $6 million in new debt and $4 million in new equity.

Upon consulting with financial advisors, TechInnovate finds that due to their increased leverage, the new debt will carry an interest rate of 7% (after tax), which is higher than their existing debt. The new equity issuance will also command a higher required return of 12% from investors due to market conditions and dilution concerns.

Here's the calculation for the incremental cost of capital for this specific $10 million:

• New Debt Portion: $6 million / $10 million = 0.60
• New Equity Portion: $4 million / $10 million = 0.40

Using the WACC formula for the incremental capital:

Incremental Cost of Capital = (0.40 * 12%) + (0.60 * 7%)
Incremental Cost of Capital = 4.8% + 4.2%
Incremental Cost of Capital = 9.0%

Even though TechInnovate's existing WACC is 8%, the incremental cost of capital for this specific project is 9.0%. Therefore, TechInnovate should only proceed with the R&D project if its expected return exceeds 9.0%.

Practical Applications

The incremental cost of capital plays a vital role in several practical financial management scenarios:

• Project Evaluation: When assessing new ventures, particularly those requiring significant additional funding, businesses use the incremental cost as the appropriate discount rate to calculate the project's net present value. This ensures that the hurdle rate for the project accurately reflects the cost of its specific financing.
• Optimal Capital Budgeting: Companies often have a limited budget for capital expenditures. By understanding the incremental cost of capital, they can prioritize projects that offer returns above this marginal cost, maximizing shareholder value.
• Capital Structure Decisions: As a company grows, its capital needs change. Management might consider shifting its debt financing to equity financing, or vice versa, based on how the incremental cost of each source affects the overall cost of new capital. The U.S. Securities and Exchange Commission (SEC) provides guidance on various pathways companies can use to raise capital, each with its own associated costs and regulatory requirements³.
• Monetary Policy Analysis: Changes in central bank interest rates, such as those set by the Federal Reserve, directly influence the risk-free rate and, consequently, the cost of both debt and equity. When central banks implement rate hikes, the incremental cost of capital for businesses can increase, potentially impacting their willingness to invest in new projects². The Australian Competition & Consumer Commission (ACCC) also discusses how the risk-free rate, often tied to government bond rates, is a key input into calculating the cost of debt and equity capital¹.

Limitations and Criticisms

While valuable, the incremental cost of capital has limitations. One challenge lies in accurately forecasting the cost of future financing. Market conditions, investor sentiment, and a company's financial performance can change rapidly, making precise predictions difficult. Furthermore, distinguishing between the incremental cost and the general Weighted Average Cost of Capital (WACC) can be complex, especially for businesses with continuously evolving capital needs.

A primary critique is that in practice, firms rarely raise capital in discrete "blocks" with clearly defined incremental costs. Instead, financing decisions are often ongoing and intertwined, making it difficult to isolate the exact cost of the "next" dollar. Moreover, focusing too narrowly on the incremental cost for a single project might overlook the broader implications for the overall capital structure and existing investor expectations. Over-reliance on debt, for example, might initially seem cheap but can significantly increase financial leverage and the risk of bankruptcy, eventually raising the cost of all capital.

Incremental Cost of Capital vs. Weighted Average Cost of Capital

The incremental cost of capital and the Weighted Average Cost of Capital (WACC) are both measures of a company's financing costs, but they serve different purposes and represent different aspects of capital expense.

While WACC provides a broad overview of a company's average financing expense, the incremental cost of capital offers a more precise, forward-looking measure essential for evaluating new projects and making specific funding decisions. The confusion often arises because the WACC calculation uses the costs of debt and equity, similar to the incremental calculation, but the WACC typically reflects the average cost of capital already in place or a target mix, rather than the true marginal cost of acquiring new funds.

FAQs

Why is the incremental cost of capital important for businesses?

The incremental cost of capital is important because it provides the most accurate discount rate for evaluating new investment opportunities. It ensures that a company only undertakes projects that are expected to generate returns higher than the cost of the specific new funds required to finance them, thus maximizing shareholder wealth.

How does risk affect the incremental cost of capital?

As a company seeks to raise more capital, especially after exhausting cheaper sources, it may be perceived as riskier by investors and lenders. This increased risk perception typically leads to higher interest rates on new debt and a higher required return on investment for new equity, thereby increasing the incremental cost of capital.

Can the incremental cost of capital be lower than the existing WACC?

Yes, it is possible. If a company has recently undertaken very expensive financing, and new market conditions or improved financial health allow it to raise additional capital at a lower rate than previous increments, then the incremental cost of capital could theoretically be lower than the existing average Weighted Average Cost of Capital. However, it is more common for the incremental cost to increase as more capital is raised.

What factors can cause the incremental cost of capital to change?

Several factors can influence the incremental cost of capital, including changes in prevailing interest rates, the company's credit rating, the amount of new capital being sought, the specific mix of debt financing and equity financing used for the new funds, and overall market liquidity conditions.