Marginal Cost of

Capital

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Marginal Cost of Capital

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What is the Marginal

Cost of Capital?

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The marginal cost of capital is the cost of raising

an additional dollar of a fund by the way of equity,

debt, etc. It is the combined rate of return required

by the debt holders and shareholders for the

financing of additional funds of the company.

Marginal Cost of
Capital Formula

Marginal Cost of Capital Formula = Cost of

Capital of Source of New Capital Raised

The weighted marginal cost of capital Formula = It

is calculated in case the new funds are raised

from more than one source and it is calculated as

below:

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Weighted Marginal Cost of Capital Formula

= (Proportion of Source1 * After-Tax Cost of
Source1) + (Proportion of Source2 * After-
Tax Cost of Source2) +….+ (Proportion of
Source * After-Tax Cost of Source)

Examples of Marginal
Cost of Capital

Let us understand the following examples:

You can download this Marginal

Cost of Capital Excel Template
here – Marginal Cost of Capital
Excel Template

Example #1
Company present capital structure has funds from

three different sources i.e., equity capital,

preference share capital and the debt. Now the

company wants to expand its current business

and for that purpose, it wants to raise the funds of

$ 100,000. The company decided to raise capital

by issuing equity in the market as according to

the present situation of a company it is more

feasible for the company to raise capital through

the issue of equity capital rather than the debt or

preference share capital. The cost of issuing

equity is 10 %. What is the marginal cost of

capital?

Solution:

It is the cost of raising an additional dollar of a

fund by the way of equity, debt, etc. In the

present case, the company raised the funds by

issuing the additional equity shares in the market

for $ 100,000 cost of which is 10 % so the

marginal cost of capital of the raising of new

funds for the company will be 10 %.

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Example #2
The company has a capital structure and the

after-tax cost as given below from different

sources of funds.

The firm wants to further raise the capital of $

800,000 as it is planning to expand its project.

Below are the details of the sources from which

the capital is raised. The after-tax cost of debt will

remain the same as present in the existing

structure. Calculate the marginal cost of capital of

the company.

Solution:

Calculation of the weighted marginal cost of the

capital:

WMCC = (50 % * 13 %) + (25 % * 10 %) + (25 %

* 8 %)

WMCC = 6.50 % + 2.50 % + 2.00 %

WMCC = 11 %

Thus the weighted marginal cost of the capital of

raising new capital is 11 %.

Please refer given excel template above for detail

calculation.

Advantages

It aims in the change of overall cost of

capital because of the raising of one more

dollar of the fund.

It helps in decision making whether or not to

raise further funds for business expansion

or new projects by discounting the future

cash flows with a new cost of capital.

It helps in deciding by what means the new

funds to be raised and in which proportion.

Disadvantages

It ignores the long term implications of

raising a new fund.

It doesn’t aim at maximization of

shareholder’s wealth unlike the weighted

average cost of capital.

This concept can’t be applied to a new

company.

Important Points

The marginal cost of capital will

increase in slabs and not linearly reason
being a company may decide of
financing a defined portion of new
investment by re-investing the earnings
or raising the majority by debt and/or
preference share so as it can maintain
the target capital structure. What is to
be noted that the re-investment of
earnings can be done without
hampering the cost of equity. But as
and when the proposed capital exceeds
the consolidated amount of retained
earnings and debt and/or preferred
stocks which are being raised in order
to maintain the target capital structure,
the cost of capital will also get
increased.

Conclusion

It is the weighted average cost of the new

proposed capital funding calculated by using their

corresponding weights. The marginal weight

implies the weight of that additional source of

funds among the entire proposed funding. In case

if any company decides to raise additional fund

through various sources through which already

funding have been done earlier and the additional

raising of the fund will be in the same ratio as

they were earlier existing then the marginal cost

of capital will be same as that of the weighted

average cost of capital.

But in the real scenario, it might happen that

additional funds will be raised with some different

components and/or in some different weights. In

this, the marginal cost of capital will not be equal

to the weighted average cost of capital.

Recommended
Articles

This has been a guide to what is the Marginal

Cost of Capital and its definition. Here we discuss

its formula along with examples of the marginal

cost of capital. We also discuss the advantages

and disadvantages. You can learn more about

accounting from following articles –

Flotation Cost Meaning

Overview of Short Term Finance

Benefit Cost Ratio

Formula of Cost of Capital

Examples of Opportunity Cost

Calculate WACC

Overcapitalization

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