Corporate Finance - Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost of the last dollar of capital raised, essentially the cost of another unit of capital raised. As more capital is raised, the marginal cost of capital rises.
With the weights and costs given in our previous example, we computed Newco's weighted average cost of capital as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.12)
WACC = 0.084, or 8.4%

We originally determined the WACC for Newco to be 8.4%. Newco's cost of capital will remain unchanged as new debt, preferred stock and retained earnings are issued until the company's retained earnings are depleted.

Example: Marginal Cost of Capital
Once retained earnings are depleted, Newco decides to access the capital markets to raise new equity. As in our previous example for Newco, assume the company's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2.00 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. Newco's cost of new equity (kc) is thus 12.3%, as calculated below:

kc = 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)

Answer:
Using this new cost of equity, we can determine the WACC as follows:

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) + (0.55)(0.123)
WACC = 0.086, or 8.6%

The WACC has been stepped up from 8.4% to 8.6% given Newco's need to raise new equity.

Figure 11.1

 

Look Out!
At some point, as the company continues to raise capital, the MCC can be higher than the WACC.

MCC Vs. WACC
The marginal cost of capital is simply the weighted average cost of the last dollar of capital raised. As mentioned previously, in making capital decisions, a company keeps with a target capital structure. There comes a point, however, when retained earnings have been depleted and new common stock has to be used. When this occurs, the company's cost of capital increases. This is known as the "breakpoint" and can be calculated as follows:

Formula 11.9

Breakpoint for retained earnings = retained earnings
                                                                     wce

Example:

For Newco, assume we expect it to earn $50 million next year. As mentioned in our previous examples, Newco's payout ratio is 30%. What is Newco's breakpoint on the marginal cost curve, if we assume wce = 55%?

Answer:
Newco's breakpoint = $50 million (1-0.3) = $63.6 million
0.55

Thus, after Newco raises roughly $64 million of total capital, new common equity will need to be issued and Newco's WACC will increase to 8.6%.

Factors that affect the cost of capital can be categorized as those that are controlled by the company and those that are not.

Factors Affecting the Cost of Capital


Related Articles
  1. Bonds & Fixed Income

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  2. Fundamental Analysis

    DCF Analysis: Calculating The Discount Rate

    By Ben McClure Contact Ben Having projected the company's free cash flow for the next five years, we want to figure out what these cash flows are worth today. That means coming up with an appropriate ...
  3. Investing

    Weighted Average Cost Of Capital (WACC)

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
  4. Economics

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  5. Fundamental Analysis

    Evaluating Retained Earnings: What Gets Kept Counts

    A company's retained earnings matter. Be investment-savvy and learn how to analyze this often overlooked information.
  6. Professionals

    Top Things To Know For An Investment Banking Interview

    Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
  7. Stock Analysis

    Home Depot's 6 Key Financial Ratios (HD)

    Learn about important financial ratios used to determine the performance of retailer Home Depot; these give a quick snapshot of the company's profitability.
  8. Markets

    EVA: What Does It Really Mean?

    By David Harper, (Contributing Editor - Investopedia Advisor) Contact David As we performed a sequence of calculations to find Disney's (DIS) 2004 economic profit, we discovered that despite ...
  9. Investing Basics

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  10. Investing News

    Apple's $12 Billion Bond Issue Meant to Boost WACC

    Apple, Inc. announced that it would issue $12 billion in corporate bonds to the public in order to return profits to shareholders via dividends and a share buyback program of equivalent size.
RELATED TERMS
  1. Weighted Average Cost Of Capital ...

    Weighted average cost of capital (WACC) is a calculation of a ...
  2. Economic Spread

    1. A performance metric that is equal to the difference between ...
  3. Traditional Theory Of Capital Structure

    The theory that when the Weighted Average Cost of Capital (WACC) ...
  4. Capitalization

    1. In accounting, it is where costs to acquire an asset are included ...
  5. Capitalized Cost

    An expense that is added to the cost basis of a fixed asset on ...
  6. Capitalization Of Profits

    Converting a company's retained earnings, which represent the ...
RELATED FAQS
  1. What does a high weighted average cost of capital (WACC) signify?

    Find out what it means for a company to have a relatively high weighted average cost of capital, or WACC, and why this is ... Read Answer >>
  2. How do interest rates affect the weighted average cost of capital (WACC) calculation?

    The interest rate is one of many external factors that can change the inputs in the weighted average cost of capital (WACC) ... Read Answer >>
  3. How do you calculate the ratio between debt and equity in the cost of capital

    Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
  4. Why do I need to unlever beta when making WACC calculations?

    Dive into weighted average cost of capital calculations, and see why firms both unlever and re-lever beta to compare debt ... Read Answer >>
  5. What's the difference between weighted average cost of capital (WACC) and internal ...

    Both weighted average cost of capital (WACC) and internal rate of return (IRR) are great measures for assessing value, but ... Read Answer >>
  6. What is the difference between the cost of capital and required return?

    Take a look at the primary conceptual differences between an investor's required rate of return and an issuing company's ... Read Answer >>
Hot Definitions
  1. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  2. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  3. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  5. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  6. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
Trading Center