Marginal Cost of Capital (MCC)

Concept and Significance of Marginal Cost of Capital

Definition and Importance

Marginal Cost of Capital (MCC) is the rate a firm must pay to raise one additional unit of new capital. In other words, it's the cost of the last rupee or dollar of capital a business acquires. Unlike the average cost of capital, which considers the total pool of funds, MCC focuses directly on Incremental financing decisions, making it especially relevant when evaluating new investments or projects.

• MCC is a weighted average of costs from various sources—debt, equity, retained earnings—reflecting the proportions used in the new financing mix.
• It changes dynamically as a firm raises more capital, since new tranches often come with higher costs due to increased risk, market conditions, or exhausted lower-cost funding sources.
• Firms use MCC to determine whether expected returns on new investments justify undertaking them. If a project's return meets or exceeds the MCC, it adds value; if not, it should be reconsidered.

Relationship between MCC and WACC

a. Conceptual Comparison

Weighted Average Cost of Capital (WACC) represents the average cost of all capital currently employed by the firm, weighted by their respective proportions in the capital structure. This is a backward-looking, composite measure. In contrast, MCC is a forward-looking measure, evaluating the cost of sourcing new capital for Future investments.

It's not uncommon for MCC to diverge from WACC, especially when a firm exceeds its existing capacity of lower-cost funds and must tap into more expensive sources, causing the MCC to rise above the average.

b. Practical Implications

• In capital budgeting, WACC is typically used to evaluate ongoing projects and the firm's overall health, while MCC guides specific investment decisions requiring new funding.
• When a company raises new capital, it must ensure that expected project returns are compared against the relevant MCC, not the historical WACC, to avoid underestimating the risk-adjusted hurdle rate.

Breakpoints in MCC Schedule

a. What Are Breakpoints?

Breakpoints mark the thresholds at which the cost of a particular source of capital increases. This occurs when a company exhausts cheaper sources (like retained earnings) and must rely on more costly alternatives (like issuing new equity or higher-interest debt).

• For each source of capital, a breakpoint is calculated where the current cost structure changes. For example, retained earnings may be sufficient for the first tranche, after which new equity (with flotation costs) becomes necessary.
• Each breakpoint leads to a step-up in the MCC schedule.

b. Breakpoint Calculation

To calculate a breakpoint for a funding source:
Breakpoint = Amount of funds available at current cost / Proportion of that source in capital structure

For instance, if retained earnings of ₹10 lakh are available and equity forms 50% of the capital structure, the breakpoint is ₹20 lakh. Beyond this, the firm must issue new equity, increasing the overall MCC.

c. MCC Schedule Illustration

The MCC schedule graphically depicts how the cost of capital rises as more funds are raised. Each breakpoint corresponds to a new step on the schedule, reflecting a higher weighted average cost for the next tranche of capital.

Use in Investment Decision-Making and Optimal Capital Budget Determination

a. Investment Decision-Making

Managers use the MCC schedule to evaluate projects systematically. Starting from the lowest MCC, projects with expected returns above this threshold are selected, moving up the schedule as capital is allocated. This ensures only value-accretive projects are chosen, maximizing shareholder wealth.

• Each project's internal rate of return (IRR) is compared with the relevant MCC for its funding tranche.
• Projects are ranked by IRR, with capital allocated sequentially until the MCC exceeds the IRR of the next project.

b. Determining the Optimal Capital Budget

The optimal capital budget is found at the point where the IRR of the last accepted project equals the MCC for that capital tranche. This is the intersection of marginal benefit and marginal cost—beyond this, additional investments would destroy value.

Purpose: Cost of New Capital vs. Average Cost and Its Role in Incremental Decision-Making

Core Distinction and Importance

The cost of new capital (MCC) often differs from the average cost (WACC) due to factors such as flotation costs, increased financial risk, and changing market conditions. New capital may come at a premium, especially after cheaper internal sources are exhausted.

• Using MCC ensures that only those projects which compensate for the true current cost of additional funds are accepted.
• Relying on WACC for incremental decisions can distort investment appraisals, potentially leading to overinvestment or underinvestment.

MCC is the relevant hurdle rate for evaluating new investments, ensuring the firm doesn’t erode value by accepting projects that fail to compensate for the actual cost of obtaining additional funds.

Example

Suppose: A company has the following capital structure: 50% debt (after-tax cost 10%), 50% equity (cost 14%). It has ₹10 lakh in retained earnings and plans to finance new projects in equal proportion.

1. For the first ₹20 lakh (using all retained earnings):
   MCC = (0.5 × 10%) + (0.5 × 14%) = 12%
2. Once retained earnings are exhausted, new equity (with flotation cost) raises cost to 16%. For the next tranche:
   MCC = (0.5 × 10%) + (0.5 × 16%) = 13%

As the company raises more capital, the MCC increases. Projects earning above 12% are viable up to ₹20 lakh; above 13% for the next tranche, and so on. This process ensures disciplined, value-focused capital allocation.