Definition
The Marginal Cost of Capital (MCC) is a finance term that refers to the cost of the last dollar of new capital being raised by a company. It measures the average rate of return that a firm must earn on its new investment so that the market value of its shares stays constant. In essence, it is the cost of obtaining further capital, often used to determine a company’s investment risk level.
Key Takeaways
- Marginal Cost of Capital (MCC) is a fundamental concept in financial management. It refers to the cost of the last unit of capital raised by a firm, in other words, the incremental cost of obtaining extra finance.
- MCC is essential because it helps companies determine at what point it becomes too expensive to finance new projects, thus influencing key investment decisions. Higher MCC might suggest investing further may dilute the company’s earnings.
- The MCC schedule can exhibit an upward trend as companies exhaust their cheaper sources of finance and are compelled to utilize more expensive sources. It’s essential to balance funding sources to manage and maintain the marginal cost of capital at an optimum level.
Importance
The Marginal Cost of Capital (MCC) is a critical financial term as it represents the cost a company incurs for acquiring additional capital, either in form of debt, equity, or a mix.
It plays a significant role in guiding a company’s investment decisions, emphasizing projects or investments that would generate returns above the MCC.
By understanding their MCC, companies can ensure efficient capital management, keeping the costs of raising new capital at optimum.
It also serves as an essential tool in the capital budgeting process, where it’s used alongside the investment opportunities schedule to identify the optimal capital budget for a company.
By balancing MCC and expected returns, companies can maximize shareholder wealth and foster long-term financial sustainability.
Explanation
The Marginal Cost of Capital (MCC) is a vital tool used by organizations to understand the cost of obtaining additional capital to fund new investments. Primarily, this method is quite important as it helps businesses in deciding whether they should pursue a particular investment or not. It reflects the weighted average cost of the last dollar of capital raised by a firm, providing an encompassing view of the potential return the investment should provide.
This figure must exceed the potential investment’s return; otherwise, the firm will decrease its value. Moreover, MCC serves as a decisive element in the investment appraisal procedure. Businesses often use this to form an optimal capital budget in the process of capital budgeting.
If a project’s internal rate of return exceeds the MCC, the project is seen as viable and potentially profitable for the company, hence it gets a green light. Conversely, if the estimated rate of return is lesser than the MCC, the project is considered as a potential drain on the organization’s resources and may be rejected. Thus, the Marginal Cost of Capital forms the basis for many strategic financial decisions within a firm.
Examples of Marginal Cost of Capital
Investment in Machinery: A manufacturing company wants to invest in a new piece of machinery that will increase its production capacity. However, the interest rate on funds to purchase the machine may increase because lending institutions recognize the higher risk associated with further investment. Hence, the additional cost of borrowing that the firm has to bear in order to invest in the new machine is a clear example of the marginal cost of capital.
Expansion of Business Operations: In expanding a business to a new location or market, a business will require further capital either through borrowing or issuing new shares. If, as a result of the expansion, interest rates or the required return on equity increases, the additional cost incurred to raise this new capital is the marginal cost of capital. This may influence the business’s decision to proceed with the expansion.
Research and Development Projects: A pharmaceutical company that plans to invest in a new research and development project will need to allocate additional funds. The additional capital can be generated from retained earnings, new equity or debt. The cost associated with each form of financing may increase as the company looks to secure them, due to the perceived added risk from the lender’s or investor’s perspective. This additional cost to raise the necessary capital for the project is considered the marginal cost of capital.
Frequently Asked Questions about Marginal Cost of Capital
What is Marginal Cost of Capital?
The marginal cost of capital (MCC) is the cost that a company incurs to obtain additional capital (in the form of debt, equity, or a combination of both). The MCC represents the cost of the last dollar of capital raised, essentially telling a company the cost of their next potential financing dollar.
Why is the Marginal Cost of Capital Important?
MCC is crucial in capital budgeting since it helps corporations decide whether to invest in a new project. A project should generate a return greater than the MCC to add value back to the company and ultimately, the shareholders.
How is the Marginal Cost of Capital Calculated?
The MCC is determined by the weighted average cost of capital (WACC). The WACC takes the average cost of all sources of capital (equity, debt, retained earnings, among others) into account, with each source weighted proportionally to its use in the company’s capital structure.
How can a Company Reduce its Marginal Cost of Capital?
A company can reduce its MCC by improving its capital structure. This could mean reducing the cost of its debt, increasing profitability leading to more retained earnings, or optimizing their mix of debt and equity to lower the WACC.
Does the Marginal Cost of Capital Change?
Yes, the MCC can change as it depends on factors that fluctuate such as interest rates, corporate tax rates, levels of retained earnings, the company’s debt ratio, and investors’ expectations of the company’s future performance.
Related Entrepreneurship Terms
- Cost of Debt: This is the effective rate a company pays on its current debt, including bonds, loans, or any other type of debt the company has.
- Cost of Equity: This is the return a company requires to decide if an investment meets capital return requirements. It is derived from the Gordon Growth Model and determined by dividends, growth, and the stock price.
- Weighted Average Cost of Capital (WACC): This is the average rate of return a company is expected to pay its investors. The weights are the fraction of each financing source in the company’s capital structure.
- Investment Decision: It is the decision made by companies regarding which investments should be funded and which ones should be eliminated based on the capital budgeting process.
- Capital Structure: This is a mix of a company’s long-term debt, specific short-term debt, common equity, and preferred equity which is ultimately used to finance its overall operations and growth.
Sources for More Information
- Investopedia: This is a leading finance and investment educational website which covers a wide range of topics including marginal cost of capital.
- Corporate Finance Institute: Their website offers a detailed explanation of the concept of the marginal cost of capital and its significance in finance.
- Khan Academy: This online educational platform provides lessons and useful insights about various finance topics, including marginal cost of capital.
- The Balance: Their finance and career advice articles are in-depth and helpful, giving you a comprehensive understanding of the marginal cost of capital.
