How to Calculate the Incremental Cost of Capital?

The incremental cost of capital represents the specific, forward-looking cost a company incurs when it decides to raise additional funds for a new project. It is not a historical measure but an estimate of the cost associated with the next dollar of capital raised. This concept is distinct from the company’s overall existing cost of capital because it focuses exclusively on the new funds required for future endeavors.

A company’s decision to pursue a new venture is tied to its ability to fund it profitably. The incremental cost of capital provides the benchmark for this evaluation. By calculating this cost, a company establishes the minimum rate of return a new project must achieve to be financially viable, ensuring new investments are expected to create value.

Components of New Capital

To determine the incremental cost of capital, a company must identify the sources for the new funds. The overall cost is a blend of the individual costs of the primary components: new debt, new preferred stock, and new common equity. Each financing method has unique characteristics and cost implications.

New debt is capital acquired through borrowing, such as issuing new corporate bonds or securing loans from financial institutions. A company with new debt is obligated to make periodic interest payments and repay the principal amount at a future date. The cost is the interest rate required to attract lenders, adjusted for tax benefits.

New preferred stock is a hybrid security that involves issuing new shares that pay a fixed dividend to investors. Unlike debt interest, these dividend payments are not tax-deductible. Preferred stockholders have a higher claim on company assets and earnings than common stockholders but do not have voting rights.

New common equity is capital raised by selling new shares of common stock, which can be done through a public offering or private placement. This represents an ownership stake and does not require fixed payments. Instead, investors expect a return through potential stock price appreciation and non-guaranteed dividends.

Calculating the Cost of Each Component

Once the sources of new capital are identified, the next step is to calculate the cost associated with each one. This process involves specific formulas for debt, preferred stock, and common equity, which form the foundation for the overall incremental cost of capital.

The cost of new debt is based on the return new lenders demand, estimated by the yield to maturity (YTM) on the company’s newly issued, long-term bonds. The YTM represents the total return an investor expects if they hold the bond to maturity. Because interest payments on debt are tax-deductible, the effective cost is lower than the stated rate. The after-tax cost of debt is calculated by multiplying the pre-tax cost (YTM) by one minus the company’s marginal tax rate.

Calculating the cost of new common equity is more complex as there is no required payment. The most accepted method is the Capital Asset Pricing Model (CAPM), with the formula: Cost of Equity = Risk-Free Rate + Beta × (Expected Market Return – Risk-Free Rate). The risk-free rate is the yield on a long-term government bond, Beta measures a stock’s volatility relative to the market, and the expected market return is the anticipated return on the broader stock market.

For new preferred stock, the calculation is the annual dividend payment per share divided by the net issuing price. The net issuing price is the stock’s market price minus flotation costs, which are fees paid to investment banks for their services. The formula is: Cost of Preferred Stock = Annual Dividend / Net Issuing Price.

Determining the Incremental Weighted Average Cost of Capital

After calculating the individual costs, the next step is to combine them into a single rate known as the incremental Weighted Average Cost of Capital (WACC). This figure represents the blended, forward-looking cost of new financing for a specific project. It is a weighted average because it accounts for the proportion of each type of capital used.

The “incremental” aspect is a key distinction, as the WACC uses the target capital structure for the new project, not the company’s current structure. It reflects the specific mix of debt and equity the company intends to use for the new investment. For example, if a company plans to finance a project with 40% debt and 60% equity, those are the weights used in the calculation.

The formula for the incremental WACC is a sum of the weighted costs of each capital component: WACC = (Weight of Equity × Cost of Equity) + (Weight of Preferred Stock × Cost of Preferred Stock) + (Weight of Debt × Cost of Debt × (1 – Tax Rate)).

To illustrate, consider a project financed without preferred stock. Assume a company’s cost of equity is 10%, its pre-tax cost of debt is 6%, and its marginal tax rate is 21%. If it finances the project with 60% equity and 40% debt, the WACC would be calculated as follows: (0.60 × 10%) + (0.40 × 6% × (1 – 0.21)). This results in a WACC of 7.896%.

This final percentage is the minimum return the proposed project must generate to cover its financing cost. It synthesizes all financing components into a single rate for evaluating the financial attractiveness of the new investment.

Application in Capital Budgeting

The incremental cost of capital is central to capital budgeting, the process companies use to evaluate and select long-term investments. It serves as a “hurdle rate” or discount rate in financial models to assess a project’s viability. A project’s expected returns must exceed this rate to be considered a worthwhile use of company resources.

One common application is calculating a project’s Net Present Value (NPV). This analysis forecasts all future cash flows associated with a project and discounts them to their present value using the incremental cost of capital as the discount rate. If the NPV is positive, the project is expected to generate returns greater than its financing costs, adding value to the company. A negative NPV suggests the project will not be profitable enough to justify the investment.

The incremental cost of capital is also used as a benchmark against a project’s Internal Rate of Return (IRR). The IRR is the discount rate at which the NPV of a project’s cash flows equals zero, representing the project’s expected rate of return. For a project to be accepted, its IRR must be greater than the incremental cost of capital, ensuring the anticipated return surpasses the cost of the funds.