Cost of capital refers to the discount rate used for calculating the present value of the future cash flow streams (Moyer, McGuigan, Rao, & Kretlow, 2012). Historical cost of capital refers to cost of the fund that has already been used for financing a project. The historic cost of capital is calculated based on the past data. The weight of each component capital used in a project with their respective cost is used in determining historic coat of capital. It helps in evaluating the past performance of the firm by comparing it with the standard costs of capital and predicting the future costs (Classification of Cost of Capital).
Marginal cost of capital (MCC) can be defined as the cost of raising an additional rupee of capital. It is the cost incurred in raising new funds. It is derived by calculating average cost of capital using marginal weights, the proportion of the funds the firm intends to invest. The marginal cost increases with the increase in capital raised due to the flotation cost involved in the process of issuing sticks for generating additional capital. However, it may be equal to the average cost of capital if the funds are raised in proportional manner and the component cost of capital remain unchanged.
The most significant role of marginal cost of capital is to evaluate the new investment project. If the rate of return offered by the project is equal to greater than the MCC, it is selected otherwise we reject it. The marginal cost is relevant for evaluating new investment project because of the following reasons;
It eliminates the confusion regarding whether to use book value weight or market value weight of capital in computing cost of capital.
It provides real time cost of capital for the proposed project that helps in taking more objective decision.
It reflects current opportunity cost available for the firm along with the current risk associated with the investment project.
It helps in calculating the break-even point: the point where marginal rate of return earned on new investment will equal the MCC.
The concept of historical cost of capital and marginal cost of capital can be clarified with the help of following example:
A company is using 40% debt and 60% equity to finance a project with respective cost of each component being 15% and 12%. The weighted average cost of capital will be 0.415+0.612 = 13.2%.
If the company decides to raise new capital by issuing common stock that requires floatation coat of 2% and will change the capital structure to 30% debt and 70% equity. Then the MCC of the firm will be 0.315+0.7(12+2) = 14.3%.
Thus the marginal cost of capital increases with the increase in amount of capital raised.
Cost of capital refers to the discount rate used for calculating the present value of the future cash flow streams (Moyer, McGuigan, Rao, & Kretlow, 2012). Historical cost of capital refers to cost of the fund that has already been used for financing a project. The historic cost of capital is calculated based on the past data. The weight of each component capital used in a project with their respective cost is used in determining historic coat of capital. It helps in evaluating the past performance of the firm by comparing it with the standard costs of capital and predicting the future costs (Classification of Cost of Capital).
Marginal cost of capital (MCC) can be defined as the cost of raising an additional rupee of capital. It is the cost incurred in raising new funds. It is derived by calculating average cost of capital using marginal weights, the proportion of the funds the firm intends to invest. The marginal cost increases with the increase in capital raised due to the flotation cost involved in the process of issuing sticks for generating additional capital. However, it may be equal to the average cost of capital if the funds are raised in proportional manner and the component cost of capital remain unchanged.
The most significant role of marginal cost of capital is to evaluate the new investment project. If the rate of return offered by the project is equal to greater than the MCC, it is selected otherwise we reject it. The marginal cost is relevant for evaluating new investment project because of the following reasons;
It eliminates the confusion regarding whether to use book value weight or market value weight of capital in computing cost of capital.
It provides real time cost of capital for the proposed project that helps in taking more objective decision.
It reflects current opportunity cost available for the firm along with the current risk associated with the investment project.
It helps in calculating the break-even point: the point where marginal rate of return earned on new investment will equal the MCC.
The concept of historical cost of capital and marginal cost of capital can be clarified with the help of following example:
A company is using 40% debt and 60% equity to finance a project with respective cost of each component being 15% and 12%. The weighted average cost of capital will be 0.415+0.612 = 13.2%.
If the company decides to raise new capital by issuing common stock that requires floatation coat of 2% and will change the capital structure to 30% debt and 70% equity. Then the MCC of the firm will be 0.315+0.7(12+2) = 14.3%.
Thus the marginal cost of capital increases with the increase in amount of capital raised.
References
Classification of Cost of Capital. (n.d.). Retrieved from MBA Knowledge Base: mbaknol.com/financial-management/c...
Moyer, R. C., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management (12th ed.). Oklahoma: Cengage Learning.