MARGINAL COST OF

CAPITAL

Prof:- Sameer Kathuria

Marginal cost of capital Definition
• Marginal cost of capital Definition
• The WACC applicable to the next dollar of the total new
financing.
• Capital is any money used to finance a business and/or its
operations.
• Capital can be acquired from many different sources:
traditional debt or equity financing or owner financing, grants,
gains on investment capital, retained earnings, accrual
financing contracts and forward payment agreements on
capital.
• The WMCC and cost of capital change over time.
 • Once retained earnings are depleted,
Newco decides to access the capital
markets to raise new equity. Newco,
assume the company's stock is selling for
$40, its expected ROE is 10%, next year's
dividend is $2.00 and the company
expects to pay out 30% of its earnings.
Additionally, assume the company has a
flotation cost of 5%. Newco's cost of new
equity (kc) is thus 12.3%, as calculated
EXAMPLE below:
Marginal Cost of Capital • kc = 2 + 0.07 = 0.123, or 12.3% 40(1-0.05)
 • Using this new cost of equity, we can
determine the WACC as follows:
WACC = (wd)(kd)(1-t) + (wps)(kps) +
(wce)(kce)
WACC = (0.4)(0.07)(1-0.4) + (0.05)(0.021) +
(0.55)(0.123)
WACC = 0.086, or 8.6%
• The WACC has been stepped up from
ANSWER 8.4% to 8.6% given Newco's need to raise
Marginal Cost of Capital new equity.
MCC Vs. WACC
• The marginal cost of capital is simply the weighted average cost
of the last dollar of capital raised. As mentioned previously, in
making capital decisions, a company keeps with a target
capital structure.
• There comes a point, however, when retained earnings have
been depleted and new common stock has to be used. When
this occurs, the company's cost of capital increases.
• This is known as the "breakpoint" and can be calculated as
follows:
MCC Vs. WACC
• Breakpoint for retained earnings = retained earnings
Wce

• Example:
For Newco, assume we expect it to earn $50 million next
year. As mentioned in our previous examples, Newco's payout
ratio is 30%. What is Newco's breakpoint on the marginal cost
curve, if we assume wce = 55%?
 • Newco's breakpoint = $50 million (1-0.3)
= $63.6 million 0.55
• Thus, after Newco raises roughly $64
million of total capital, new common
equity will need to be issued and Newco's
WACC will increase to 8.6%.
• Factors that affect the cost of capital can
be categorized as those that are
ANSWER controlled by the company and those
that are not.
MCC Vs. WACC
 • A firm wishes to raise funds up to Rs. 10,00,000 and finds that its WMCC depends upon the
amount of funds raised. The firm has set pattern of financing i.e., 75% shareholders funds and
25% debt. The shareholders funds may be taken as consisting of retained earnings and
capital. Cost of capital for each source is given below.

• Source Amount (Rs.) Specific C/C

• Shareholders Funds up tpRs. 1,50,000 12%

• 1,50,000 – 6,00,000 14%

• 6,00,000 – 9,00,000 17%

• Bonds up tpRs. 1,00,000 10%

• 1,00,000 – 2,00,000 12%

• 2,00,000 – 3,00,000 16%

QUESTION •

• Find out WMCC at different breaking points given that

Marginal Cost of Capital
• Tax rate is 50%.

• Retained earnings of Rs.1,50,000 will be from current earnings at 12% cost of capital.

• Additional shareholder funds will have to be raised by issue of share capital.

 • Estimation of WMCC breaking points :

• Step 1 : Composition of shareholders funds 75%

• Composition of bonds 25%

• Step 2 : Find out breaking points at different levels of each source as follows :

• Source Amt.(Rs.) Weight Break Point(Rs.) Total Funds(Rs.) Specific C/C

• SH Funds 1,50,000 .75 2,00,000 up to 2,00,000 .12

• 6,00,000 .75 8,00,000 2,00,000 – 8,00,000 .14

9,00,000 .75 12,00,000 8,00,000 – 12,00,000 .17

ANSWER •

• Bonds 1,00,000 .25 4,00,000 up to 4,00,000 .05

Marginal Cost of Capital
• 2,00,000 .25 8,00,000 4,00,000 – 8,00,000 .06

• 3,00,000 .25 12,00,000 8,00,000 – 12,00,000 .08

 • Step 3 : Calculate WMCC for each range of financing.

• Range(Rs.) Source Weight C/C Weighted

C/C WMCC

• Up to 2,00,000 SH Funds .75 .12

.900

• Debt .25 .05 .125 .1025

• 2,00,000 – 4,00,000 SH Funds .75 .14 .1050

• Debt .25 .05

.125 .1175

• 4,00,000 – 8,00,000 SH Funds .75 .14

.1050
ANSWER
• Debt .25 .06 .150
Marginal Cost of Capital .1200

• 8,00,000 – 12,00,000 SH Funds .75 .17

.1275

• Debt .25 .08 .200 .1475

•
 • Therefore, the WMCC at different levels of
financing are :
•
• Levels of Financing
WMCC
•
• Up to Rs. 2,00,000
10.25%
• 2,00,000 – 4,00,000
ANSWER 11.75%
Marginal Cost of Capital
• 4,00,000 – 8,00,000
12.00%
• 8,00,000 – 12,00,000
14.75%
THANK YOU

SUBMITTED BY:-
SHUBHAM RANA
MUKUL