Define marginal cost of capital.
Answers
Marginal cost of capital is the weighted average cost of the last dollar of new capital raised by a company.
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Explanation:
Marginal Cost of Capital
Marginal cost of capital is the weighted average cost of the last dollar of new capital raised by a company. It is the composite rate of return required by shareholders and debt-holders for financing new investments of the company. It is different from the average cost of capital which is based on the cost of equity and debt already issued.
The weighted average cost of capital (WACC), the most common measure of cost of capital used in capital budgeting and business valuation, is the weighted average of the marginal cost of common stock, marginal cost of preferred stock and marginal after-tax cost of debt.
The distinction between average cost of capital and marginal cost of capital is important. The marginal cost of capital rises as the company raises more and more capital. This is because capital is scarce, just like any other factor of production, and must be compensated through a higher required return. The return available on new projects must be compared with the marginal cost of capital and not the average cost of capital and the projects should be accepted only when the expected return is higher than the required return.
Marginal cost of capital increases in steps and not linearly. This is because a company can finance a certain portion of new investments by reinvesting earnings and raising enough debt and/or preferred stock to maintain the target capital structure. The reinvestment of earnings comes without any increase in cost of equity. However, as soon as the expected capital exceeds the combined amount of retained earnings and debt and/or preferred stock raised to maintain the target capital structure, the marginal cost of capital increases.