Marginal Cost Of Funds Definition

The marginal cost of funds captures the increase in financing costs for a business entity as a result of adding one more dollar of new funding. As an incremental cost or differentiated cost, the marginal cost of funds is important when making capital structure decisions. When selecting among capital sources or financing types, financial managers use the marginal cost of funds to isolate those sources of financing methods which incrementally add the smallest amount to total funding costs.

The marginal cost of funds is often confused with the average cost of funds, which would be calculated by computing a weighted-average of all forms of finance and their respective cost of funds.

Marginal Cost Of Funds Explained

While many investors only think of the marginal cost of funds regarding money borrowed from someone else, it's also important to think of it regarding 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 rate of interest it could have earned if it had invested that money instead of spending it on construction.

As businesses increase their funding levels, the suppliers of various forms of capital keep a close eye on one another. For instance, if a firm issues new stock, or buys back stock, creditors could become uneasy, even though they’re technically suppliers of debt capital. In turn, equity investors may frown on businesses borrowing excessively, because theory says 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 earned by the last additional unit of capital. This represents the market rate of interest at which it starts to pay off to undertake capital investment.