What Is the Marginal Cost of Funds?

The term marginal cost of funds refers to the increase in financing costs for a business entity as a result of adding one more dollar of new funding to its portfolio. As an incremental cost or differentiated cost, the marginal cost of funds is important when businesses need to make future capital structure decisions. Financial managers use the marginal cost of funds when they select capital sources or financing types. These financing methods incrementally add the smallest amount to total funding costs.

Key Takeaways

  • The marginal cost of funds is the increase in financing costs for a business as a result of adding one more dollar of new funding to its portfolio.
  • This figure is important when businesses need to make future capital structure decisions.
  • Financial managers use the marginal cost of funds when selecting capital sources or financing types.

Understanding the Marginal Cost Of Funds

The incremental cost of producing an additional unit is referred to as the marginal cost. In order to calculate the marginal cost, a business divides the change in cost by the total change in production. The cost of funds is the amount of money a company pays to run its operations. For instance, the cost of funds for a financial institution is the interest it pays to its customers for things savings accounts and other simple investment vehicles. The lower the cost of funds, the better the returns. Higher costs, though, result in less-than-average returns.

The marginal cost of funds, therefore, represents the average amount of money it costs a company to add one more unit of debt or equity. Since it's an incremental cost, the marginal cost of funds is also referred to as a company's incremental cost of capital.

Suppliers of various forms of capital keep a close eye on one another as businesses increase their funding levels. So if a firm issues new stock or does a stock buyback, creditors may become uneasy, even though they’re technically suppliers of debt capital. In turn, equity investors may frown upon businesses that borrow excessively. That's because theory suggests this may lead to financial distress, thereby hurting equity suppliers as well. 

A related but separate concept is the marginal efficiency of capital, which measures the annual percentage yield (APY) earned by the last additional unit of capital. This yield represents the market rate of interest at which it starts to pay off to undertake capital investment.

Special Considerations

While many investors only think of the marginal cost of funds as money borrowed from someone else, it's also important to think of it as money borrowed from oneself or a company's assets. In this instance, the marginal cost of funds is the opportunity cost of not investing existing funds elsewhere and receiving interest on it. For example, if a company uses $1,000,000 of its cash to build a new factory, the marginal cost of funds would be the interest rate it could have earned if it invested that money instead of spending it on construction.

Marginal Cost of Funds vs. Average Cost of Funds

The marginal cost of funds is often confused with the average cost of funds. This metric is calculated by computing a weighted average of all forms of finance—short-term and long-term financing—and their respective cost of funds. The average cost of funds is also called a company's average cost of capital.