Basic Understanding Of Marginal Cost Of Capital

June 3rd, 2008 Comments off
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In earlier article, we understand the concept of cost of capital or weighted average cost of capital of a firm.

This article reviews the concept of marginal cost of capital:

The basic concept of Marginal Cost Of Capital

  • Incremental cost the firm will need to pay to raise an additional dollar of capital
  • This concept assumes that the capital is raised according to the optimal capital structure proportion

Simple Illustration:

  • For example, let’s say Company XYZ has the following capital structure:

Source

$

Weight

Cost(After tax)

Weighted Cost

Debt

10m

50%

6%

3.0%

Common stock (internal)

10m

50%

15%

7.5%

20m

10.5%

Due to increase need for higher capital expenditure, Company XYZ’s capital has now changed:

Source

$

Weight

Cost(After tax)

Weighted Cost

Debt

30m

75%

10%

7.5%

Common stock (internal)

10m

25%

15%

3.8%

40m

11.3%

With the raising of incremental $20m of capital, the marginal cost of capital has increased by 0.8% from 10.5%(old) to 11.3%.(new)

This can be due to a variety of reasons like issuance of new common stock(more expensive) instead of using on retained earnings or for this case, it is due to higher volume of debt borrowed, the lender(s) to Company XYZ has increased its interest rate

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Financial Accounting

 
 

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