What is Marginal Cost of Capital?
Posted by meenakshi in Article, Financial, What is Marginal Cost of Capital?
In economics, the marginal cost of capital refers to the additional costs associated with the security of an extra unit of investment. It is usually expressed as a percentage, similar to an annual percentage rate or yield. In simple terms, marginal cost of capital (MCC) is equal to the cost of financing a greater dollar investment. In general, the more money a company is trying to borrow, the higher the interest on these funds, so the higher the marginal cost of capital. MCC should not be confused with the marginal cost of production, which refers to the extra cost of producing an additional unit of product.
Companies have three basic options for financing new capital, such as equipment or factories. These include reinvesting retained earnings, borrowing from investors using shares, or borrow from banks and taking on debt. Most companies wishing to invest in new capital will begin by investing retained earnings, because this form of financing has no associated costs.
After the retained earnings are exhausted, the company's marginal cost of capital compared to the expected return of this new investment to determine how much to borrow, or how many shares to be issued. If the expected return of borrowing more money is greater than the MCL, the company will take on the debt. If the MCC is higher than the expected return, then the company will probably not take on new debt.
To understand why the marginal costs of capital increases as companies try to borrow more, or more investors to find, take into account the simple law of supply and demand. The more holders of shares a company have the greater the supply of stock available. With so many existing investors, companies will have difficulty finding a supply of suitable investors for their shares. To attract more investors to buy these additional shares, the company will have to pay a higher price to investors, resulting in a higher MCC.
It can be very easy to marginal cost of capital to be confused with total costs. Understand the difference; consider a company that wants $ 100,000 U.S. Dollars (USD) loan to invest in new equipment. A bank offers this loan at an annual cost or the total investment of 12 percent. If the company wishes to borrow $ 110,000 USD, the bank will take 15 percent interest on the additional $ 10,000 USD to the added risk of the larger loan to cover. This means that the MCC is 15 percent on the additional capital, while the overall cost of capital is between 12 and 15 percent.
Companies have three basic options for financing new capital, such as equipment or factories. These include reinvesting retained earnings, borrowing from investors using shares, or borrow from banks and taking on debt. Most companies wishing to invest in new capital will begin by investing retained earnings, because this form of financing has no associated costs.
After the retained earnings are exhausted, the company's marginal cost of capital compared to the expected return of this new investment to determine how much to borrow, or how many shares to be issued. If the expected return of borrowing more money is greater than the MCL, the company will take on the debt. If the MCC is higher than the expected return, then the company will probably not take on new debt.
To understand why the marginal costs of capital increases as companies try to borrow more, or more investors to find, take into account the simple law of supply and demand. The more holders of shares a company have the greater the supply of stock available. With so many existing investors, companies will have difficulty finding a supply of suitable investors for their shares. To attract more investors to buy these additional shares, the company will have to pay a higher price to investors, resulting in a higher MCC.
It can be very easy to marginal cost of capital to be confused with total costs. Understand the difference; consider a company that wants $ 100,000 U.S. Dollars (USD) loan to invest in new equipment. A bank offers this loan at an annual cost or the total investment of 12 percent. If the company wishes to borrow $ 110,000 USD, the bank will take 15 percent interest on the additional $ 10,000 USD to the added risk of the larger loan to cover. This means that the MCC is 15 percent on the additional capital, while the overall cost of capital is between 12 and 15 percent.
