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. Investing

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
  2. Personal Finance

    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.
  3. Investing

    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.
  4. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  5. Investing

    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.
  6. Tech

    Understanding Facebook's Capital Structure (FB)

    Facebook's strong revenue and earnings have allowed solid expansion of the company's equity capitalization, resulting in little debt in its capital structure.
  7. Investing

    Valuing Firms Using Present Value of Free Cash Flows

    When trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today.
  8. Investing

    Lower Your Fees With Mutual Fund Breakpoints

    The lower the sales charge you pay, the greater your returns. Find out how to cash in.
  9. Investing

    Understanding Verizon's Capital Structure (VZ)

    Verizon has a highly leveraged capital structure, and this debt capitalization and the company's equity have affected its enterprise value.
Frequently Asked Questions
  1. When are Beneficiaries of a Will Notified?

    Learn when the beneficiaries of a will must be notified, and understand how this requirement varies depending on whether ...
  2. Why Does Larry Page Pay Himself a $1 Salary?

    Google co-founder Larry Page continues to take an annual salary of only $1 as chief executive officer.
  3. What is Common Stock and Preferred Stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ...
  4. Can CareCredit be Used for Family Members?

    Learn more about the available options that CareCredit offers to pay for out-of-pocket medical procedures with little to ...
Trading Center