Marginal Cost of Capital

Definition

The marginal cost of capital (MCC) is a concept used in financial management for capital budgeting purposes. Actually, it is the weighted average cost of the last $1 of new capital raised.

Companies can raise new capital from:

• retained earnings
• issuing new stock
• issuing new debt

Retained earnings are the only source of financing to maintain the target capital structure without issuing new stock. Therefore, the marginal cost of capital remains the same if new capital is raised. The drawback of this financing source is that the amount of new capital is limited by the amount of retained earnings.

Issuing new stock causes the dilution of earnings per share (EPS). In other words, net profit is distributed among more shareholders, so earnings per share is lower. As a consequence, the stock price will decline, and investors will accept a higher required rate of return. Thus, the marginal cost of capital raised by the issue of new stock is getting higher as the amount of stock outstanding grows.

Issuing new debt usually has a negative effect on a company’s creditworthiness. As a result, lenders will compensate for increasing credit risk by raising interest rates. Thus, the marginal cost of debt will increase as the proportion of debt in total capital grows.

Graph

The marginal cost of capital tends to increase as the amount of new capital grows. This relationship is illustrated in the graph below.

Formula

As mentioned above, the weighted marginal cost of capital is the weighted cost of new capital raised. The formula used to calculate it is as follows:

WMCC = w_d×r_d×(1-T) + w_ps×r_ps + w_cs×r_cs + w_re×r_re

where r_d is the pretax cost of new debt; T is a marginal tax rate; r_ps is the cost of new preferred stock; r_cs is the cost of new common stock; r_re is the cost of retained earnings; w_d, w_ps, w_cs, and w_re represent the proportion of debt, preferred stock, common stock, and retained earnings in the new capital structure.

Marginal cost of capital vs. WACC

Do not be confused by the weighted average cost of capital (WACC) and the marginal cost of capital! WACC refers to the cost of a company’s total capital or, less commonly, to the cost of capital for a given project. In turn, MCC refers to the average cost of the last portion of capital raised.

Retained earnings breakpoint

If management of a company maintains the target capital structure, the maximum amount of new capital that can be raised without issuing new stock is limited by the amount of retained earnings. This amount is called the retained earnings breakpoint and can be calculated as follows:

Retained Earnings Breakpoint = RE ÷ w_e

where RE is the amount of retained earnings in a given accounting period, and w_e is the proportion of equity in the target capital structure.

If the amount of new capital is lower or equal to the retained earnings breakpoint, the marginal cost of capital will not increase.

Investment opportunity schedule and optimal capital budget

The concept of marginal cost of capital is a very important issue when the capital budget of a company is being prepared. Management of a company has to consider an investment opportunity schedule (IOC) to determine the need for additional capital. The investment opportunity schedule is a graph where investment projects are ordered from the highest internal rate of return (IRR) to the lowest. An example is shown in the figure below.

As the main objective of a company’s management is to maximize shareholder value, projects with a positive net present value (NPV) should be accepted. In other words, if the IRR of a given project is higher than the cost of invested capital, it will have a positive NPV and should be accepted.

We should combine the marginal cost of capital and the internal rate of return curves in one plot to determine the optimal capital budget.

The intersection of the MCC and IRR curves is a breakpoint, where the NPV of a project equals zero. The projects should be rejected because their IRR is lower than the marginal cost of capital. The projection from the intersection point on the x-axis is in a dollar amount of the optimal capital budget. If this project is fulfilled, shareholder value will be maximized.

Example

A company is considering a project with an initial cost of $15,000,000 and an expected internal rate of return of 11.5%. The amount of retained earnings in the last financial quarter is $3,000,000 at a cost of 15.7%. A bank has offered a $12,000,000 loan at a 9.5% interest rate. The corporate tax rate is 25%.

The management of a company should accept a project if the internal rate of return is higher than the cost of invested capital. Let’s calculate the weighted marginal cost of capital.

Since the cost of capital is lower than the IRR, the company should accept the project.