As we know that a company can raise funds via different sources, such as debt, common stock, and preference shares. Each of these different forms of capital has its own cost to the company. The marginal cost of capital is the cost to raise one additional dollar of new capital from each of these sources.
It is the rate of return that shareholders and debt holders expect before making an investment in a company. The marginal cost of capital usually goes up as the company raises more capital. This is because capital is a scarce resource.
Does Not Increase Linearly
It is vital to understand that the marginal cost of capital does not increase linearly. A company can finance some part of the new investment by reinvesting earnings and via debt or preference shares to maintain an optimal capital structure. But, once the expected capital requirement exceeds the retained earnings and funds raised through debt or preferred stock, the marginal cost of capital would increase. Why increase? It is because the next source is equity, and that is costly.
Let’s say that it is not possible for the company to keep raising capital at a constant cost. The same concept applies to other resources as well. A company can’t even continue to employ the workforce by keeping the wage constant. As a company plans to raise new capital via different sources, the weighted average cost of each dollar also starts increasing.
Components of Cost of Capital
Marginal Cost of Debt
The marginal cost of debt is a component of the marginal cost of capital. It is the interest rate that investors expect, adjusted for taxes. For instance, a business raises a new debt at an interest rate of 7%, and the tax rate is 15%. In this case, the marginal cost of debt would be 0.07*(1-0.15) 5.95%.
Marginal Cost of Equity
It is the expected dividend growth rate plus the ratio of dividend for next year to the company’s stock price, adjusted for the cost of stock issuance. For instance, if the stock issuance cost is 10% of the current stock price of the company. If the stock price is $30, then the adjusted stock price is $30*(1-0.10) = $27. And, if the expected dividend growth rate is 5% and the dividend for the next year is $2, the marginal cost of common stock capital would be ($2/$27)+5% =12.40%.
In the case of preference shares, adding a dividend growth rate does not make any sense, as a company usually pays dividends on preference shares at a constant growth rate. So, the cost of preferred stock capital is the ratio of preferred dividends to net issuance proceeds (Gross proceeds less issuance costs).
For instance, a company raises $2 million by issuing preference shares and pays an annual dividend of $100,000. In this case, the marginal cost of preferred stock capital is 100,000/2000000 = 5%.
Weighted Marginal Cost of Capital
It is the sum of the weighted marginal cost of all forms of capital. Continuing with the above examples, suppose a company raises 20% via debt, 50% via equity, and 30% via preferreds. In this case, the weighted marginal cost of capital will be (20%*5.95%)+(60%*12.40%)+(30%*5%) 10.13%.
How it’s Useful?
Marginal capital is very important and plays a crucial role in financial analysis and asset valuation. Also, it helps management make important capital-budgeting decisions. One must not confuse it with the average cost of capital. Financial analysts usually compare a project’s return on the basis of the marginal cost of capital rather than the average cost of capital. Typically, a project with a higher expected return over the required return is considered a good project.
The term ‘Break Point’ refers to the fresh injection of investments that a company finances without an increase in the marginal cost. The point where the marginal cost of the capital curve ends its flat trend is known as the break point.
It is possible to calculate the break point by dividing the retained earnings for a period by the weight of the retained earnings in the capital structure. One can calculate the retained earnings by multiplying the net income for the period with the retention rate. Retention rate or plow-back rate is 1- dividend payout ratio.
Formula for Break point is = N1x(1-DPR)/We
Here ‘NI’ is the net income, DPR is the dividend payout ratio, and ‘We’ is the weight of the retained earnings in the capital structure that the company is aiming for.
Marginal Cost of Capital Schedule
It is a graph that explains the connection between a firm’s weighted average of each dollar of capital to new capital raised. The schedule tells analysts the change in the cost depending on the capital raised.
As a company raises more capital, the cost of various sources of capital may change due to several reasons. These can be;
- A company might not be in a position to raise any further debt of similar nature as in the past.
- Tests performed on the debt structure of the company might deter them from raising money through debt of a similar seniority level.
- If the company moves away from the existing capital structure, then the marginal cost of capital would increase to reflect those deviations.
Optimal Capital Budget
The return on investment for a company has a negative correlation with the increasing marginal cost of capital. As the company starts raising additional capital, its return on investments starts to deplete. A company should continue to raise new capital until the marginal cost of capital is below or equal to the available return.
Financial Analysts also utilize the marginal cost of capital concept for security valuation. An analyst uses this concept in addition to discounted cash flow (DCF) valuation models. The analyst goes with the WACC of the company for valuation if the cash flows are to the company’s provider of the capital. On the other hand, an analyst goes for the cost of equity capital to find the present value of the cash flows if the cash flows belong to the owner of the company.