Marginal cost of capital: Meaning, Criticisms & Real-World Uses

What Is Marginal Cost of Capital?

The marginal cost of capital (MCC) is the cost of the last dollar of new capital raised by a firm, representing the incremental expense associated with obtaining additional financing. It is a fundamental concept within corporate finance, playing a crucial role in a company's capital budgeting and investment decisions. As a company raises more capital, the cost of that capital typically increases because lenders and investors perceive a higher risk. This rising cost is due to various factors, including the exhaustion of cheaper sources of financing and the increased financial risk perceived as a firm takes on more debt or issues more equity. Understanding the marginal cost of capital helps firms determine the optimal amount of capital to raise for new projects.

History and Origin

The concept of the cost of capital, from which the marginal cost of capital derives, has evolved alongside modern finance theory. Early financial models focused on the overall cost of a firm's financing. However, as businesses grew and required increasingly large amounts of capital for expansion, the idea that the cost of capital might change at different levels of financing became apparent. The necessity for rigorous analysis of project profitability against the actual cost of raising the funds highlighted the importance of a marginal perspective. For instance, the Monetary Control Act of 1980, which mandated that Federal Reserve Banks price their services to recover all operating and imputed costs, including a "cost of capital" that a private firm would incur, implicitly acknowledged the need to account for the expense of capital in ongoing operations and new ventures.⁴,³ This governmental application underscores the long-standing recognition of capital costs in financial operations.

Key Takeaways

Marginal cost of capital (MCC) is the expense of acquiring an additional unit of financing.
The MCC typically increases as a company raises more capital due to higher perceived risk by investors.
Companies use MCC in capital budgeting to compare the return on a project to the cost of financing it.
Identifying "break points" in the MCC schedule is essential for understanding when the cost of capital changes.
MCC helps firms determine the optimal scale of new investment to maximize shareholder value.

Formula and Calculation

The marginal cost of capital is not a single formula but rather a concept that manifests as a schedule or curve. It reflects the weighted average cost of capital (WACC) at different levels of new capital raised. As a company raises more capital, it typically exhausts its cheapest sources of funds, such as retained earnings or low-interest debt financing. Beyond certain thresholds, known as break points, the firm must resort to more expensive forms of financing, such as issuing new common stock or debt with higher interest rates.

The general formula for the weighted average cost of capital (WACC), which is calculated for each tranche of new capital to derive the MCC schedule, is:

\text{WACC} = (W_d \times K_d \times (1 - T)) + (W_p \times K_p) + (W_e \times K_e)

Where:

(W_d) = Proportion of debt in the capital structure
(K_d) = Cost of debt before tax
(T) = Corporate tax rate
(W_p) = Proportion of preferred stock in the capital structure
(K_p) = Cost of preferred stock
(W_e) = Proportion of equity in the capital structure
(K_e) = Cost of equity

The marginal cost of capital increases as (K_d) or (K_e) increase for subsequent capital tranches.

Interpreting the Marginal Cost of Capital

Interpreting the marginal cost of capital involves understanding its relationship with investment opportunities. A firm should undertake all projects whose expected rate of return exceeds the marginal cost of the capital required to finance them. As a company considers more projects, the total amount of capital it needs increases. Simultaneously, the return on additional projects typically declines, while the marginal cost of capital rises. The intersection of the investment opportunity schedule and the marginal cost of capital schedule indicates the optimal capital structure and the level of investment that maximizes the firm's value. Managers should prioritize projects with the highest expected returns first, moving down the list until the expected return falls below the marginal cost of obtaining the necessary funds.

Hypothetical Example

Consider XYZ Corp., which needs to raise capital for expansion. Their current capital structure and costs are as follows:

Debt: $10 million at 5% interest (after-tax cost = 3.5% assuming a 30% tax rate)
Equity (retained earnings): $15 million, with a cost of equity of 10%

XYZ Corp. can raise an additional $5 million using retained earnings before needing to issue new common stock. They can also issue up to $7 million in new debt at 5% before their lenders demand a higher interest rate of 6% on any further debt.

Let's calculate the marginal cost of capital at different levels:

Scenario 1: First $20 million of new capital (from available debt and retained earnings)

XYZ Corp. decides to maintain its target capital structure proportions (e.g., 40% debt, 60% equity).
For the first $20 million, they might use $8 million from low-cost debt and $12 million from retained earnings.
The weighted average cost of capital for this tranche is relatively low.

Scenario 2: Capital needs exceed $20 million, but within the limits of low-cost debt and retained earnings

If XYZ needs $25 million, the additional $5 million would still come from the cheapest sources available within their target capital structure. The MCC remains the same as long as they don't hit a break point.

Scenario 3: Capital needs exceed $25 million (hitting the retained earnings break point)

Suppose XYZ needs $30 million. After exhausting the initial $15 million in retained earnings, any further equity financing must come from issuing new common stock, which typically has a higher cost of equity due to flotation costs. If the cost of new common stock rises to 12%, the MCC for the capital raised beyond the $25 million mark will increase, reflecting this higher equity cost.

This demonstrates how the marginal cost of capital increases in steps as the firm exhausts cheaper financing options and moves to more expensive ones.

Practical Applications

The marginal cost of capital is a vital tool for corporate financial management. Companies utilize it extensively in capital budgeting decisions, comparing the expected return of potential projects with the cost of the capital needed to fund them. A project is generally considered financially viable if its expected internal rate of return or net present value exceeds the marginal cost of capital.

For instance, when companies plan large-scale investments, they assess the overall amount of financing required and then identify the corresponding marginal cost of capital from their MCC schedule. This process helps prioritize projects effectively, ensuring that only those capable of generating returns above their financing cost are undertaken. Furthermore, regulatory bodies, such as the SEC Division of Corporation Finance, require extensive disclosures from companies, which include details about their financing activities.² This transparency allows investors and analysts to evaluate a company's financial health and its ability to raise capital efficiently. Fluctuations in broader market interest rates also directly influence a firm's borrowing costs and, consequently, its marginal cost of capital.

Limitations and Criticisms

Despite its utility, the marginal cost of capital framework has limitations. One challenge is accurately forecasting future financing costs and the specific break points where these costs will increase. Market conditions are dynamic, and the availability and cost of debt financing and equity financing can change rapidly due to economic shifts or investor sentiment.

Another criticism revolves around the difficulty of precisely determining the cost of equity, especially for private companies or those with volatile stock prices. Moreover, maintaining a strict target capital structure can be challenging in practice, as market opportunities or unexpected events may necessitate deviations from the desired mix of debt and equity. External factors, such as shifts in global monetary policy or geopolitical events, can also introduce significant uncertainty. For example, the International Monetary Fund (IMF) frequently highlights how external shocks and policy uncertainties can heighten the need for robust policies to safeguard financial stability, which can impact a firm's ability and cost to raise capital.¹ Such unforeseen circumstances can make the precise estimation and application of the marginal cost of capital more complex.

Marginal Cost of Capital vs. Weighted Average Cost of Capital

The terms marginal cost of capital (MCC) and weighted average cost of capital (WACC) are closely related but distinct. WACC represents the overall average cost of all the capital a company has raised to finance its assets, considering the proportion of each financing source (debt, equity, preferred stock) and their respective costs. It's a static measure of the average cost of a company's existing capital.

In contrast, the marginal cost of capital (MCC) specifically refers to the cost of additional capital that a firm seeks to raise for new projects or expansion. While the WACC formula is used to calculate the MCC for each successive tranche of new capital, the MCC is a dynamic concept. It acknowledges that as more capital is raised, the incremental cost may increase. Therefore, a firm's WACC might represent a point on the MCC schedule, typically at its current capital level, but the MCC schedule itself illustrates how that cost changes as larger amounts of new capital are acquired.

FAQs

What causes the marginal cost of capital to increase?

The marginal cost of capital typically increases as a firm raises more capital because it exhausts less expensive sources of funds like retained earnings and low-interest debt. As it seeks more financing, it must often issue new common stock or debt at higher interest rates, which are generally more costly. Additionally, lenders and investors may demand higher returns for providing more capital, perceiving increased financial risk.

How is marginal cost of capital used in capital budgeting?

In capital budgeting, the marginal cost of capital is compared to the expected returns of potential investment projects. A company should accept projects whose expected rate of return (e.g., internal rate of return) exceeds the marginal cost of the capital required to fund them. This helps ensure that the firm undertakes profitable ventures and maximizes shareholder wealth.

What are break points in the marginal cost of capital schedule?

Break points are specific levels of new capital raised where the cost of one of the financing components (e.g., debt or equity) increases. For example, a break point might occur when a company exhausts its available retained earnings and must issue new common stock, which typically has a higher cost of equity due to flotation costs. Each break point signifies a shift to a higher marginal cost of capital.

Does the marginal cost of capital always increase?

While the general tendency is for the marginal cost of capital to increase as more funds are raised, it might remain constant over certain ranges if a company has access to significant amounts of relatively cheap financing. However, eventually, as the firm's financing needs grow, it will likely encounter break points where the incremental cost of capital rises.