Every business needs capital to finance its plans for growth. Capital is any amount of money used to finance a business or its operations, and it can include various sources and methods. These sources may include traditional debt and equity financing or owner financing.
Other forms of financing include grants, gains on investment capital, retained earnings, forward payment agreements on capital, and accrual financing contracts. There is a cost of capital related to the forms of capital. Let’s explore the two methods calculating the cost of the capital – marginal cost of capital and weighted cost of capital.
Difference Between The Marginal & Weighted Average Cost Of Capital
The marginal cost of capital
Different types of capital, such as debt, equity, stock, etc. are used in different amounts and for different costs. While we evaluate the cost of additional funds raised, it is called the marginal cost of capital. Marginal cost is the cost of capital that is marginal and may include a basic interest rate cost structure. For example, if Company A raises funds by issuing equity shares in the market amounting to $100,000 at an interest rate of 10% per annum, compounded annually, the marginal cost of capital for raising new funds for the company will be 10%, i.e., $10,000.
However, the true cost of capital for a company may not accurately be determined by the simple average cost of capital. For example, if Company A is financed by$100,000 of debt at 7%, $50,000 of equity at 12% and $75,000 of owner financing at 0%, the average cost of capital would be 7% + 12% + 0% divided by 3 = 19%/3 = 6.33%. This cost is not accurate since it does not take into account the different amounts of money at different rates. In order to overcome this limitation in the estimation, the weighted average cost of capital is utilized.
The weighted average cost of capital
The weighted average cost of capital multiplies the amount of capital by the rate of cost for that capital as a proportional percentage of total capital. It then averages two or more costs that are calculated similarly. It can be better comprehended by dividing the former sentence into two concepts: the average amount of total capital and the percentage cost of capital type. As per the above concept, an example is presented below:
Concept 1: Average amount of total capital
Suppose three types of capital are employed; one at 44.44% of total capital, second at 22.22% of capital, and third at 33.33% of total capital. Now, adding together all three of these sums up to 99.99% of total capital. These percentages are the proportions by which each rate of the capital cost is to be multiplied by to obtain the weighted average cost of capital.
Concept 2: Percentage cost of capital
To calculate the percentage cost of capital, the marginal cost of capital is multiplied by the proportional cost of capital. To continue with the above example, Company A uses $7,000 at 7% of debt at 44.44% of the total capital that equals a proportional rate of 3.11%. Using the same method of calculation for $50,000 of equity at 12% and $75,000 of owner financing at 0%, WACC becomes 3.11% + 2.66% + 0% = 5.77%/3 = 1.9233%. So the weighted average cost of capital is 1.9233% and is a more accurate representation of Company A’s cost.
The marginal cost of capital and the weighted average cost of capital are methods of calculating the cost of capital that help a company to manage its capital budgeting and asset management operations. Without knowing the cost of capital, a company is not finely able to determine that projects and investments at what rate of return are needed to break even or subdue the initial cost to acquire a profit margin. Marginal Cost of Capital may involve less calculation than WACC, though, the marginal cost may be calculated by incorporating tax rates, overhead, insurance, or any other cost linked with acquiring that specific funds as capital.
The weighted average cost of capital calculation can be inclusive of the marginal cost of capital calculation because each type of capital, when weighted itself, has a marginal cost. Thus, the marginal cost of capital and the weighted average cost of capital is not essentially mutually exclusive. Furthermore, the weighted average cost of capital typically can never be a component of the marginal cost of capital. In contrast, the inverse of this fact is true for the marginal cost of capital. The marginal cost of capital and WACC are validated as significant cost variables used in accounting, finance, project management, strategic management, apart from the non-corporate analysis of the company such as in auditing, investment analysis, external financing, and tax regulation.