Marginal Cost of CapitalDefined along with Formula & How to Calculate

Patrick Louie
Last Updated: June 7, 2022
Date Published: June 7, 2022

Running a business isn’t something that you can do out of nothing.

The fact is, you need resources in order to run a business.

Resources such as cash to pay for operating expenses or to purchase assets to facilitate business operations.

You’d also need resources to keep your employees happy (such as by paying their salaries and wages on time).

Let’s refer to this resource as capital for now.

Even a business that isn’t asset-heavy (such as service-based businesses) will be needing capital.

And like most things in this world, capital isn’t free.

Depending on where it’s sourced, the cost will vary.

Now let’s say that you’ve been running a business for several years now.

This means that you pretty much have the capital you need to maintain it.

But what if you’re planning to expand your business but its current level of capital cannot accommodate such expansion?

That’s where the term “marginal cost of capital” comes in.

Basically, it answers the question “how much would it cost to add one more dollar of capital?”.

In this article, we will go in-depth on what the marginal cost of capital is.

We will be learning its definition.

We will also learn how we can apply it to a business.

Let’s get started!

marginal cost of capital

What is the Marginal Cost of Capital?

Capital is not an unlimited resource.

Sure, you can pool all of your money as capital into your business.

But when that runs out, you’ll have to resort to outside sources such as debt and equity funding.

The thing with funds from outside sources is that they come with a cost.

Sources of equity funding (e.g. investors) will expect returns for their investment.

Sources of debt financing (e.g. creditors) will require interest payments.

This cost of adding more capital is what we refer to as the marginal cost of capital.

The marginal cost of capital is an important factor to consider when a business needs to make future capital structure decisions.

It affects the maximum profits that the business can earn after all.

The higher the cost of capital, the more it takes away from the business’s revenue.

It’s important to understand that the marginal cost of capital does not increase linearly.

Rather, it’s more likely to increase in slabs.

For example, a business can finance a portion of its new investment via reinvesting earnings (i.e. retained earnings) as well as through debt or preference shares.

In doing so, the business can maintain its desired capital structure.

However, when the capital requirement exceeds the current level of retained earnings and capital raised from debt or preference shares, the business will have to source funds from equity.

That’s when the marginal cost of capital increases as equity can be more costly than debt or preference shares.

Capital is a scarce resource.

Because of this, it’s virtually impossible for a business to continue raising it at a constant rate.

Just think of it in terms of demand and supply.

As the demand for capital increases or its supply decreases, the cost of acquiring it also increases.

Calculating the Marginal Cost of Capital

Calculating the marginal cost of capital is pretty simple.

We only need to get the weighted average of the after-tax cost of the additional capital.

If the additional capital comes from one only one source, then there’s no need to calculate as the marginal cost of capital will equal the cost of acquiring from such source.

Putting it into formula form, it should look like this:

Marginal Cost of Capital = After-Tax Cost of Acquiring New Capital

-or-

Marginal Cost of Capital = (After-Tax Cost of Source 1 x Portion of Source 1) + (After-Tax Cost of Source 2 x Portion of Source 2) +  (After-Tax Cost of Source 3 x Portion of Source 3)…

The first formula applies when there’s only one source of new capital.

The second formula applies when there are multiple sources of new capital.

To illustrate, let’s have some examples:

Example#1

The Alice company has a capital structure that has a mix of 50% debt and 50% equity.

It is planning to expand its operations. However, it needs to raise at least $250,000 of additional capital to execute the plan.

After much deliberation and research, the board of directors decided to raise the additional capital through the issuance of common shares (equity capital) as it’s currently cheaper than sourcing through debt or preference shares.

Per market research, the after-tax cost of acquiring capital through equity funding is 12%.

Alice company would want to know the marginal cost of capital.

Answer:

In the case above (Alice company), there is only one source of additional capital, and it is through the issuance of new stocks (equity funding).

As such, we really don’t need to do any calculation to determine the marginal cost of capital.

In this case, we only need to know the after-tax cost of acquiring the additional from the said source, which is 12%.

Therefore, the marginal cost of capital is 12%.

Example#2

Suppose that the board of the Alice company cannot entirely raise the additional capital from just the issuance of common shares.

They can only raise as much as $100,000 of additional capital from it.

As such, they have to raise funds through multiple sources instead (e.g. through debt funding or preference shares).

The board of the Alice company decided to raise the additional capital as follows:

  • $100,000 through equity funding (issuance of common shares)
  • $75,000 through debt funding (through a bank loan)
  • $75,000 through the issuance of preference shares

The after-tax cost of equity funding is still at 12%. The after-tax cost of debt is currently 15%.

Lastly, the after-tax cost of funds sourced through preference shares is 13%.

What is the marginal cost of capital?

Answer:

Before we proceed with the calculation of the marginal cost of capital, we first need to know the proportion of funds to be raised from each source.

To do so, we only need to divide the funds to be raised from each source by the total funds to be raised.

In this case, the total funds (additional capital) amount to $250,000.

To compute the proportion of funds to be raised through the issuance of common shares (equity funding):

$100,000 ÷ $250,000 = 40%

To compute the proportion of funds to be raised by securing a bank loan (debt funding):

$75,000 ÷ $250,000 = 30%

To compute the proportion of funds to be raised through the issuance of preference shares:

$75,000 ÷ $250,000 = 30%

We can now proceed with the calculation of the marginal cost of capital:

Marginal Cost of Capital = (After-Tax Cost of Source 1 x Portion of Source 1) + (After-Tax Cost of Source 2 x Portion of Source 2) +  (After-Tax Cost of Source 3 x Portion of Source 3)

= (12% x 40%) + (15% x 30%) + (13% x 30%)

= 4.8% + 4.5% + 3.9%

Marginal Cost of Capital  = 13.2%

As per computation, the marginal cost of capital is 13.2%.

Why the Marginal Cost of Capital Matters

marginal cost of capital

The marginal cost of capital plays a very important in financial decisions.

As it is essentially the cost of acquiring another dollar of capital, you can use it to decide whether or not a new investment or project is worth raising in.

If the marginal cost of capital exceeds the potential returns you can gain from the new investment or project, it might need some tweaking.

You can either change the capital structure, make some budget adjustments, or cancel the whole project altogether.

At the end of the day, a project or investment that has a higher expected return than the marginal cost of capital is always preferable.

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  1. MUMA College of Business South Florida "COST OF CAPITAL (Chapter 11)" White paper. June 7, 2022

  2. jiwaji.edu "COST OF CAPITAL" Page 1 - 8. June 7, 2022