3.9 Marginal Cost of Capital
Let’s say a firm wishes to grow and has various capital projects it is considering. The Marginal Cost of Capital (MCC) is what the firm’s financing costs will run for the new project alone. This is not the same as the cost of capital for the firm overall.
We will assume that the firm is facing the following marginal component capital costs. Think of “marginal” as “incremental” in the sense that these are the costs of adding to the firm’s overall capital in order to invest in a new project. It is only the marginal costs that are relevant to the investment decision, just as it is only marginal profits that relate to the decision.
| MCC | |
| (After-tax cost of) Debt | 5% |
| Internal Common Equity | 9% |
| External Common Equity | 15% |
If the firm takes on a new project, we will assume, in the following example, that it has decided that it will use 50/50 leverage. Let’s further say that the firm will not use a mix of both internal and external equity – it will use only one or the other equity financing source. It will not use preferred stock. The firm’s marginal (weighted average) cost of capital (MCC) could therefore be either of the following:
| Financing Choice | Formulation / Calculation | MCC |
| Debt + Internal Equity | (0.5) (0.05) + (0.5) (0.09) = | 7% |
| Debt + External Equity | (0.5) (0.05) + (0.5) (0.15) = | 10% |
Let’s say the project has an initial cost of $4 million. If the firm has $2 million in internal equity, i.e., earnings, which it expects to retain this year, it could borrow another $2 million and finance the new $4 million project with a 7% weighted-average cost of (marginal) capital. If the firm uses external equity capital – either because it does not have the internal equity, because it chooses to pay dividends, or use the capital for other projects – its MCC will be 10%.
If the project requires more than $4 million, and the firm chooses not to, or is unable to, borrow more, its MCC will rise due to obtaining more external equity, which is most expensive. If it uses borrowed money, it is also possible that the cost of debt will rise due to the lenders’ demands – should the firm choose to borrow more than it already has.
If the firm chooses to modify its leverage ratio, you may alter the weights accordingly in the template above. As it stands, any independent project that requires up to, but not more than $4 million, would be accepted if its IRR exceeds 7% or 10% respectively – depending on which marginal capital structure management chooses. Keep in mind that the firm will assess the proposed project’s incremental Free Cash Flow in comparison with its incremental, or Marginal, Cost of Capital. In other words, the MCC is the project’s WACC!