What Is the Marginal Cost of Capital & Why Does It Matter?

Defining Marginal Cost of Capital

The marginal cost of capital (MCC) is the cost a company incurs to acquire one more dollar of new capital. Unlike the weighted average cost of capital (WACC), which is the average cost of all capital raised, MCC focuses on the cost of obtaining new funds for future projects. As a company raises larger amounts of capital, its cost can change due to increased risk, market capacity limitations, or the need for different financing sources.

The cost of capital is not static; it increases as a company issues more debt or equity beyond certain thresholds. For example, if a company issues substantial new debt, existing creditors or new lenders may demand higher interest rates due to perceived default risk. Similarly, once a company exhausts internally generated funds, like retained earnings, it may need to issue new common stock. Issuing new common stock incurs flotation costs, such as underwriting and legal expenses, making it more expensive than using retained earnings. This means the cost of capital increases in steps as larger volumes of new funding are required, reflecting the increasing expense of accessing deeper capital pools and the market’s response to greater financial leverage.

Understanding Capital Components and Their Costs

Companies obtain capital from three primary sources: debt, preferred stock, and common equity. Each component carries a specific cost that must be estimated. The cost of debt is usually the lowest because it is often secured and interest payments are tax-deductible for the issuing corporation. For instance, if a company borrows at 6% interest and faces a corporate tax rate of 21%, the after-tax cost of debt is 6% multiplied by (1 – 0.21), or 4.74%. This tax shield significantly reduces the effective cost of borrowing.

Preferred stock represents a hybrid form of financing, possessing characteristics of both debt and equity. Holders receive fixed dividend payments, similar to interest payments on debt, but these dividends are not tax-deductible for the issuing company. The cost of preferred stock is calculated by dividing the annual fixed dividend payment by the net price the company receives per share after any issuance costs. For example, if a preferred stock pays an annual dividend of $5 per share and the company receives $95 per share after flotation costs, its cost is approximately 5.26%.

Common equity is the most expensive source of capital. This category includes both retained earnings and newly issued common stock. Retained earnings are profits a company reinvests in the business rather than distributing as dividends. While there are no direct cash outlays for using retained earnings, there is an opportunity cost: shareholders could have received those earnings as dividends and invested them elsewhere for a return. The cost of retained earnings can be estimated using models such as the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).

When a company needs to raise capital beyond its retained earnings, it must issue new common stock. The cost of new common stock is higher than retained earnings due to flotation costs. These costs, including underwriting, legal, and administrative expenses, range from 2% to 10% of gross proceeds. These expenses reduce the net capital the company receives, increasing the effective cost of equity. Therefore, the cost of new common stock is calculated by adjusting the market price per share downward by these flotation costs before applying a model like the CAPM or DDM.

Calculating Marginal Cost of Capital

Calculating the marginal cost of capital involves extending the weighted average cost of capital (WACC) concept to successive blocks of new financing. MCC recognizes that this average cost is not constant as more capital is acquired; it increases in steps as the company exhausts cheaper sources and taps into more expensive ones. The core of MCC calculation lies in identifying “breaking points,” which are thresholds in the capital raising process.

Breaking points occur when the cost of one capital component increases, or when a company must switch to a more expensive financing source. For example, a breaking point is reached when a company fully utilizes its available retained earnings. Beyond this point, any additional equity must come from issuing new common stock, which carries higher flotation costs. Another breaking point might occur if lenders impose higher interest rates on debt beyond a certain borrowing threshold, reflecting increased financial risk.

To calculate the MCC, a company first determines its target capital structure—the optimal mix of debt, preferred stock, and common equity it aims to maintain for future investments. Then, it calculates the WACC for an initial “block” of capital, assuming it uses its lowest-cost sources, such as retained earnings and available debt at favorable rates. As the need for capital grows, the company identifies the dollar amount at which a cheaper source is exhausted or a cost increases. This amount marks a breaking point, calculated by dividing the total amount of a specific lower-cost capital component by its proportion in the target capital structure.

For each subsequent block of capital, a new WACC is calculated, reflecting the increased cost of the component that triggered the breaking point. For instance, if the breaking point for retained earnings is $100 million, the first $100 million of equity capital might use the cost of retained earnings. Any equity capital needed beyond $100 million would then incorporate the higher cost of new common stock. This iterative process results in a series of WACCs, each applicable to a specific range of total new capital, illustrating the step-up function of the MCC. This function demonstrates how the marginal cost of capital increases as the total amount of new capital raised grows, providing a realistic view of funding costs for large projects.

Applying Marginal Cost of Capital in Business Decisions

The practical application of the marginal cost of capital (MCC) is important for effective capital budgeting and investment decisions. Businesses use MCC to evaluate the financial viability of potential projects and prioritize investment opportunities. A proposed project should only be undertaken if its expected rate of return, often measured by its internal rate of return (IRR), exceeds the marginal cost of the capital required to fund it. This ensures new investments generate sufficient returns to cover their funding expenses.

By linking the project’s expected return to the MCC, companies ensure they make economically sound choices. For example, if a company considers a project requiring $150 million in new capital, it must identify the MCC for that block of funding. If the MCC for that $150 million block is, say, 10%, then the project’s expected return must be greater than 10% to be acceptable. Projects with expected returns below their corresponding MCC would destroy shareholder value, as financing costs outweigh generated benefits.

Utilizing the MCC in decision-making helps companies allocate their limited capital resources efficiently. It prevents both under-investment, where profitable projects might be overlooked, and over-investment, where projects that do not generate adequate returns are pursued. This methodical approach ensures each new investment contributes positively to the company’s financial health and maximizes shareholder wealth. Understanding and accurately applying the MCC is a guiding principle for strategic financial management.