TyroCity

Discussion on: About Marginal cost of capital

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Angel Paudel

The marginal cost of capital in simple terms can be referred to as additional cost incurred from the additional unit of capital risen (Taggart, 1991). Clarifying this with an example, when we’re borrowing money, people with better credit score and lesser risk will get lower interest rate while the rest with have slightly higher as per their risk level. Same is true for a company. Consider that they borrowed the most they could and soon they run out of the credit line from the bank. They have another option in taking out a credit card or other investors, the business in debt now has a higher risk and thus the interest rate is higher as well. So, as you keep borrowing more and more and more, the cost of capital is going to be a higher cost of capital as well. For example, with the company have 0 borrowing can borrow upto $1m at 4% interest rate but the rate will increase once that point is crossed, let’s say to 6% for the next $0.5m and it keeps on rising as the risk level, leverage of the company ability to pay off debt is lesser as well.

Historical cost specifically refers to the value of the assets that are to be found in the balance sheet. It records the original or purchased price of the asset and is shown without any changes in the historical cost (Otley, 1999). Even though they don’t include any personal opinions about how much should an asset be valued in the current time, it’s far less accurate. Let’s see this with an example. A company purchased a computer at $1,000 in 2016, the cost now of the used laptop would be somewhere around $400 however, it’s still recorded to be of $1,000 itself. Another example of the value on rise but being recorded the same would in the case of a building. Let’s assume that the company buys its corporate building at a cost of $1m in 2000. The value rose over the period tenfold every ten years and is now around $100m in 2018. However, the cost is recorded to be no different, which isn’t practical.

The marginal cost of capital makes the comparisons of assets and analysis on its changing value possible which can’t be done with the historical cost. Also, Marginal cost gives a business idea about the current aspect of the market and current valuations rather than the past record which isn’t practical in the current age. In the current world, where we can see the price of petroleum products changing every 15-days in Nepal and real-time pricing implemented in India and other parts of the world, we can’t say that the price of any asset will remain the same even after years of it being purchased by a company like in the case of historical price if used. Marginal cost is thus more accurate, gives a real picture, is reliable and assist in the decision-making process is why its relevant concept of evaluating a firm’s investment projects rather than going with the historical cost of capital.

References

Otley, D. (1999). Performance management: a framework for management control systems research. Management Accounting Research , 10 (4), 363-365.

Taggart, R. (1991). Consistent Valuation and Cost of Capital Expressions with Corporate and Personal Taxes. Financial Management , 20 (3), 8.