The cost of capital of a company represents the opportunity costs of the funds available to it for investing in different projects. Similarly, it can be defined as the required rate of return, which is a vital part of the capital budgeting process of a company. Companies need the cost of capital to evaluate different projects and select ones that are feasible and worthwhile. Usually, the cost of capital is an internal metric that companies use for decision-making purpose. This decision-making relates to the long-term objectives of a company. It is a crucial concept in both accounting and economics.
The cost of capital of a company mainly depends on its capital structure. The capital structure of a company is the mixture of its equity and debt finance. To calculate its cost of capital, the company must calculate the Weighted Average Cost of Capital (WACC). The WACC represents the average cost of equity and cost of debt of the company based on the portions of those sources of finance. Every company must calculate its WACC to use in its decision-making process. However, sometimes, the company may also calculate the Weighted Marginal Cost of Capital instead of the WACC.
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What is Weighted Marginal Cost of Capital (WMCC)?
The Weighted Marginal Cost of Capital is the marginal cost of capital of a company weighted according to the proportion of each type of finance in its capital structure. The marginal cost of capital represents the weighted average cost of every $1 new capital that a company raises. It is the composite rate of return that shareholders and debt instrument holders of a company require for new investments in it. The marginal cost of capital is different from the average cost of capital, which focuses on equity and debt that the company has already obtained.
A company calculates the average cost of capital using the Weighted Average Cost of Capital. On the other hand, it can find the marginal cost of capital using the Weighted Marginal Cost of Capital (WMCC). While both of them represent the cost of capital of a company, they represent a different type of cost of capital. While the WACC is most commonly necessary in the capital budgeting process of a company, the WMCC can also have its uses.
Companies that want to calculate the WMCC must first understand the difference between the average cost of capital and the marginal cost of capital. The marginal cost of capital of a company will rise as it gathers more equity and debt. The increase is caused because every time the company obtains finance, it must pay a higher price for it. Therefore, for new projects that need capital, companies must compare their returns with the marginal cost of capital, rather than the average cost of capital.
In most cases, an increase in the marginal cost of capital is stepped and not linear. It is because sometimes companies will have some existing capital that they can use in new projects. The rest of it, they can obtain from other sources and use it in the project. When the project is completely financed, the portion of capital that companies reinvest do no come with extra costs. Therefore, these reinvestments do no contribute to the marginal cost of capital of companies. However, the extra capital generated will cause an increase in the marginal cost of capital.
Weighted Marginal Cost of Capital (WMCC) Formula
When a company obtains new funds, it may use a single source of finance or different sources. For example, it may obtain both equity and debt finance. If the company uses only one source of finance, it can calculate its cost accordingly. For instance, if it obtains only equity finance, then it can calculate the cost of equity. Similarly, if it obtains only debt, then it can calculate the cost of debt.
However, usually, companies use more than one source of finance. Therefore, they must calculate the weighted marginal cost of capital. The calculation of the weighted marginal cost of capital is similar to that of the weighted average cost of capital. However, instead of using the formula to calculate the cost of capital, for the total capital of the company, it can be used to calculate the cost of capital of new finance only.
The Weighted Marginal Cost of Capital (WMCC) formula can, therefore, be represented as follows.
Weighted Marginal Cost of Capital = (Proportion of capital x After-tax cost of capital)1 + (Proportion of capital x After-tax cost of capital)2 + … + (Proportion of capital x After-tax cost of capital)n
In the above formula 1, 2 and n represent the source of finance. For every source of finance that the company obtains newly, it must calculate the cost of capital and then weigh it according to its proportion. After calculating the cost of capital of all sources and weighing them, the company can add them to obtain the weighted marginal cost of capital.
Example
A company, ABC Co., has an equity of $15 million and debt of $5 million in its current capital structure. It wants to invest in a new project which will require further equity of $3 million and debt of $2 million. ABC Co. wants to calculate its weighted marginal cost of capital to determine how much the new finance will cost it. To calculate the WMCC, ABC Co. must use the WMCC formula below.
Weighted Marginal Cost of Capital = (Proportion of capital x After-tax cost of capital)1 + (Proportion of capital x After-tax cost of capital)2 + … + (Proportion of capital x After-tax cost of capital)n
It means ABC Co. must only calculate the cost of capital of the newly required capital. Similarly, it can ignore the finance that is already a part of its capital structure. ABC Co. already used the CAPM model to calculate the cost of equity, which is 12%. On the other hand, it calculated the cost of debt at 9%, which is the pretax cost of debt. The corporation tax percentage of ABC Co. is 20%. Now, calculating the weighted marginal cost of capital is straightforward. Below is the calculation for the WMCC.
Weighted Marginal Cost of Capital = Weighted marginal cost of equity + Weighted marginal cost of debt
Then we get:
Weighted Marginal Cost of Capital = ($3 million / $5 million x 12%) + ($2 million / $5 million x [9% x (1 – 20%)])
Thus, Weighted Marginal Cost of Capital = (0.6 x 12%) + (0.4 x [9% x 0.8])
Weighted Marginal Cost of Capital = 7.2% + 2.88%
Hence, Marginal Cost of Capital = 10.08% or 10.1%
WMCC vs WACC
As mentioned above, there is a difference between the Weighted Marginal Cost of Capital and Weighted Average Cost of Capital. While the calculation for both the costs of capital are similar, the amounts for which they are calculated are different. The WMCC represents the cost of capital of newly obtained finance. Therefore, it denotes the costs of all finance obtained by a company that is not already a part of its capital structure. The WMCC can also refer to the cost of capital of the latest portion of finance raised by a company.
The Weighted Average Cost of Capital, on the other hand, represents the cost of capital of the overall capital structure of a company. It can be used to evaluate different projects and investments, unlike the WMCC, which only applies to new finance. The WACC can also represent the cost of capital of a specific project. Overall, the WACC will take into consideration a higher amount of capital as compared to the WMCC.
How to Use WMCC to Make Financing and Investing Decisions?
Companies can use WMCC in one of many different ways when making financing and investing decisions. First of all, the WMCC plays an important role when it comes to financial analysis and asset valuations. It also helps with capital budgeting decisions. Most financial analysts use the WMCC to compare different projects instead of the WACC. Investors can also use the WMCC when it comes to deciding between investing in different companies. The rule with WMCC is the same as WACC. Any project with an expected return above the WMCC is considered feasible.
WMCC can also be helpful in investing decisions. Companies can use the inverse relationship between WMCC and returns on projects to make decisions regarding those projects. It is because as the WMCC of finance rises, the returns from the related project declines. WMCC can help companies decide regarding different types of finance and evaluate financing options. It can also help companies make decisions regarding the right mix for the financing of a project.
Conclusion
The cost of capital is a vital concept for companies. It can be calculated using the Weighted Average Cost of Capital formula, which calculates the cost of capital of a company’s capital structure. Instead of the WACC, companies can also calculate the Weighted Marginal Cost of Capital, which is a measure of the cost of capital of only new finance. While the calculation for both of them are similar, they are still different due to the finance they consider. Companies can use the WMCC in financing and investing decisions.
